When the Time Comes to Sell Your Business
Everyone reaches that fork in the road when he or she contemplates selling some or all of the business they worked so hard to create. Perhaps they have reached an age and station in life when retirement looks appealing. Perhaps economic indicators suggest this is the perfect moment to maximize the sale price. Or maybe the entrepreneur wants to remain in business, but their organization needs an infusion of capital to remain vital and competitive.
Any number of turning points can motivate you to liquidate all, or a portion, of a business or to implement an internal succession plan that phases in new ownership. Whether you have already arrived at this crossroads or it remains years away, this life-changing decision lurks on the horizon and merits careful consideration.
Start with a Valuation
We have found that many entrepreneurs have an inflated opinion of what their business is worth. So we suggest getting a reality check with a formal valuation from a neutral outside party before pursuing a sale or considering an offer.
How will your company’s value be calculated? Price generally reflects two key drivers: profit and multiples. Profit is the amount left after all operating and amortized expenses are deducted from revenues. Multiples are an industry-specific valuation factor that relate to profitability. For example, a multiple of six means the sale price of the business would be six times the annual profit.
Multiples are not set in stone and are typically influenced by the profit margin and growth rate, business cycle ebbs and flows, as well as other factors. Here are two simple examples:
- A manufacturing business generates $5 million in profits annually and is at the bottom of the business cycle, in which the market is saturated, and product and labor costs are rising. At a multiple of six times earnings, the sale price is $30 million.
- A new cosmetics company generates $4 million in profits annually and, riding the anti-aging trend, is approaching the top of the business cycle. At a multiple of eight times earnings, the sale price is $32 million.
Notice that the company generating more profits today is deemed less valuable. That’s because its long-term prospects seem less rosy. Pricing can also reflect the level of control. For example, what if you own 49% of a company and your partner owns 51%? If you alone sell shares, you won’t attract top dollar because you do not have a controlling interest. But if you and your partner put your shares together and sell as a block, both will get a higher price.
If your ongoing enterprise remains profitable, risk doesn’t concern you, and you still have that fire in your belly, then you may want to take a step back and rethink selling. Strictly from a financial perspective, running a private company can be the best investment you make. On an after-tax basis, public markets rarely provide enough income and growth to match the cash flow of a private company. Post liquidation, it’s highly unlikely you will enjoy the same income you once enjoyed as an entrepreneur.
If you are determined to exit, consider whether your focus is on netting as much money as possible or securing a personal family legacy. Those who prefer to keep the business in the family rarely get top dollar and must address the question of which relative is up to the job of taking over the business. Family tensions can arise if Dad and Mom disagree about which child is capable of this role. Ideally, your financial advisor will help you and your family navigate the decision-making process, draw out salient information, and get all involved on the same page.
If you are approached with a purchase offer that looks favorable after due diligence, you could well reach the finish line with that single prospect. However, many entrepreneurs choose to engage an investment bank to shop their company through an auction process for the most lucrative deal. The banker will scrub financials and prepare a memorandum to attract both financial and strategic buyers. They will distribute the book, solicit indications of interest among interested buyers, and negotiate final terms with a handful of parties.
A financial buyer is one who is focused strictly on the economic return on their investment. This is generally a private equity fund that will purchase a company to sell in a few years after improving the financial picture. They may bring in their management team to restructure, strip out unnecessary costs, and increase leverage on the business. This type of buyer typically recapitalizes the company by pulling equity out and replacing it with debt before selling.
For certain buyers, the greatest value of a potential acquisition is not in current profits, but in product lines, intellectual property, or distribution channels. Strategic buyers are looking to open new markets, expand service lines, roll up and consolidate overhead, or spread costs over a larger revenue base. They may want to reach your geographic location with a “plug and play” presence in the market.
Having a strategic advantage can make your business attractive to these buyers. For example, brick-and-mortar retailer PetSmart paid $3.35 billion to acquire popular online pet product retailer Chewy.com, which was bringing in revenues of $900 million. Chewy has since been taken public with an initial public offering (IPO), and PetSmart remains the majority shareholder.
Sometimes the greatest value lies in data collected on hundreds and thousands of people to whom the acquirer can sell other things, especially if this network can be turned into recurring revenue. A good example is Dollar Shave Club, a monthly service that delivers razor blades and personal care products for men. In 2015, the company enjoyed sales of $152 million and projected over $200 million. Unilever paid $1 billion to acquire it. Using the brand’s membership list, they continue to roll out new skincare and grooming product offerings to loyal subscribers.
Strategic buyers also pay a premium multiple, sometimes on revenue before a business is profitable, for a specific product or patent they want, or to remove a competitor from the marketplace. Facebook paid a hefty $19 billion for WhatsApp because the small social media app was rapidly gaining market share. Business intelligence showed the app was transmitting more than twice the number of electronic messages as Facebook Messenger in certain regions, and Facebook wanted to prevent erosion of market share.
Perhaps the company has a strong management team poised to take over, and you anticipate transferring ownership to them. You might arrange this transition in various ways.
- You could sell to your employees through a qualified plan known as an employee stock ownership plan (ESOP), which purchases your shares through bank financing and allows the debt to be repaid with pre-tax dollars. The owners of an ESOP are the employees who buy the shares from the previous owner using bank financing.
- You could craft a formula such as the one we use ourselves at Balentine. Each year, the company is valued based on a fixed multiple of profitability. When a new partner is admitted, they buy in based on that fixed multiple, putting a third or more of the cost down and using outside bank financing for the balance. Partners have skin in the game; nothing is just “given.” Quarterly profit distributions then amortize that debt. At exit, the partner sells back to the company, which pays them back over time. This process enables Balentine to admit and retire equity partners through orderly shifts in ownership.
Another type of internal sale is the transfer of ownership within a family. Perhaps your nephew works for the company and has the skill to take over, or maybe you foresee a time when your child will be ready to become CEO. You may anticipate that the recipient(s) would be hobbled by the expense or tax burden of acquiring the company in a single transaction. To reduce the impact, you might consider creating a family entity, such as a family limited partnership, and sell or gift units of ownership to that entity at a discounted price. In this way, you might take advantage of what is known as minority share discounts or lack of marketability, so that over time, your ownership declines, and the next generation’s ownership increases.
We have seen well-intentioned entrepreneurs pass their businesses on to children who excelled in other company roles but were not ultimately suited to the demands of running a company. If you conclude that none of your children is a fit for the CEO position, you might keep them in other roles for the company, while hiring a professional manager who is not a family member to manage the business. The original family remains majority shareholders, but professional management handles the day-to-day leadership. Ford Motor Company, which once seemed headed for bankruptcy, is an excellent example. They brought in Alan Mulally, former CEO of Boeing, who orchestrated a legendary turnaround for the struggling automaker.
Your Role Post-Sale
Your role after the transaction can also influence the sales price. If you agree to remain on to transfer knowledge and smooth the transition, you often gain a higher financial reward, versus prioritizing independence and stepping away completely.
Perhaps you’re an entrepreneur who wants to stay in the game and continue to grow your company, but capital is an inhibiting factor. In other words, you could expand operations, but don’t have the money to do so. You could choose to dilute your ownership and bring in another equity owner who will provide capital to grow the business. During this process, you would also typically pull out some money from the company to give yourself some liquidity. You might continue to own 20% and they own 80%.
Ultimately, you and your buyer will need to agree about assets being transferred, the extent to which you will remain on as either an employee or consultant and any other relevant terms. Payment can be via cash, stock in the acquiring company, or a combination of both.
Purchases for stock can be an appealing element of the purchase, as they are typically tax-free. However, this is a two-edged sword. Accepting stock in place of cash puts a lot of your eggs in one basket. Your fortunes can rise and fall with the acquiring company. If you become concerned about the concentration of risk, you may have difficulty selling shares. If the acquiring company is private, it could have restrictions on stock sales, and if it’s a public company, it could be subject to SEC “insider” trading guidelines.
Often, entrepreneurs get a “second bite at the apple” by reinvesting a portion of the sale proceeds, pre-tax, in the newly acquired company. Think carefully about whether and how you will be involved in the business after you choose to sell. If you wish to exit entirely, make sure you have taken steps in the lead up to the sale to ensure prospective buyers are buying the business and management team, not just you.
In your excitement about landing a buyer, beware of rushing to the dotted line. You might miss unique opportunities for financial reward and overlook important protections.
For example, if you’ve neglected proper planning before entering into a binding letter of intent with a buyer, afterward, it could be too late to take advantage of discounting mechanisms that substantially reduce taxes for you and your heirs. Or, suppose you wanted to make a significant charitable gift with a portion of the sale proceeds. By contributing shares of your company to a donor-advised fund pre-sale, not only would you get a tax deduction, the contribution would be made with pre-tax dollars.
Cashing out or liquidating a portion of the multi-million-dollar enterprise you built from scratch can be an intoxicating prospect. For best results, before the time comes to sell your business and bank a fortune that took a lifetime to build, ask yourself: Have I consulted with my team of advisors to put proper planning in place, so that proceeds from the sale will be safe, secure and optimized?
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