The long winter is over, and the freeze by banks on lending financing is beginning to thaw. But like the changing of the seasons, it’s coming slowly.
Lenders in the United States pulled back and took refuge in loans considered safer during the 2008–2009 turmoil. To put it bluntly, says Stephen A. Frost, a partner at Hinshaw & Culbertson LLP who focuses on wealth preservation and business transition planning, “everything stopped when the market crashed in 2008 and nothing happened for two years.”
Feeling more secure, banks are financing transactions again and have cash that can be loaned at a historically low cost of capital. The transaction activity has increased from a couple years ago and generally multiples have gone up, says Daniel Barron, managing director of Northern Trust’s Family Business Group and co-author of Selling Your Business for More.
As a result, now may be the perfect time to begin preparing your business to sell or transition.
Keeping It in the Family
Whether the business is part of the family legacy, a source of income or an investment, owners considering passing down a company must look at family dynamics and ask themselves:
- Do you realistically and honestly have someone capable of running the company?
- Are there one or more children who have the skills or can be trained and are also interested in running the business?
- Can they do it in a way to foster the company’s growth and still keep the family together?
- Can the business support everyone in the next generation?
- Is the business sustainable, or is there developing technology that would make it difficult?
There is no shortage of emotional and family dynamic considerations when it comes to passing down the company to a family member or members. Entrepreneurs start their businesses out of a passion for doing something. Their children, however, may not share that passion and may even resent the business, says Jack Olson, a retired partner at the law firm of Foley & Lardner LLP.
Or, if one child is interested in the business and others are not, siblings that are not involved have a tendency to try to “milk the company,” using it as a personal piggybank and not help it grow, Frost cautions.
As a final emotional consideration, succeeding generations may see the business as a source of wealth and not share the more selfless viewpoint of the founder, Olson says.
For all of these reasons, an exit strategy must be clearly defined, especially if one family member has to buy out another. “If you just leave the stock to family members and say, ‘Good luck to you,’ it’s a recipe for disaster,” Olson says.
Corporate governance or a board of directors comprised of nonfamily members can supervise, assist with management and be an objective party, Barron suggests.
Communication also is important. It minimizes the mysteries that can create suspicion. Business owners should visit family members, share financial statements, talk about issues and challenges, and discuss how the business is going, Barron suggests.
If a successor is chosen, training should start at least a year in advance. How long depends on the nature of the business. Assuming the child already has some knowledge of the business, owners should make sure he or she also has been in a leadership position, says Bill Russell, a partner at Freeborn & Peters, LLP, a Chicago-based law firm that provides counsel to business executives. “People assume their children have this ability without testing the ability,” he says. “Give them some rope on a project and see how they do with it. See if they have that capability.”
If the founder really wants to keep the business in the family, setting up an arrangement through stockholder agreements or a trust may be the best approach. This puts a formal exit strategy in place as a stopgap, especially if nonfamily members are involved in a board of directors and can give professional, non-emotional opinions. If the family can’t agree on major corporate decisions, the company can be sold or one person can buy out other stockholders, preferably using a method where the bids are sealed. That way, it doesn’t turn into an auction, Olson says. “It keeps the next generation from fighting and forces them to live off the terms of the stockholder agreement or having the control taken away from them if they can’t decide,” he says.
Lastly, know that keeping control in the family can inadvertently drive out talent. Hard-working and ambitious employees may not stay if they believe they’ll never have a stake in the company because there is an apparent heir. Therefore, it’s important to reward nonfamily members with bonuses and opportunities to advance.
Preparing for an Outside Sale
If a business owner decides to sell, he or she must first put together a plan. “When I started 30 years ago, everyone’s exit strategy was to go public,” Olson says. “But there have been a lot of federal laws passed, and audits are required to go public as a company. So it’s not as common as it used to be.”
Coordinating with all advisors including attorneys, accountants, investment bankers or business brokers is essential when trying to find prospective buyers.
It’s also important to get an independent third-party evaluation to find out what the company is truly worth. Some owners have an inflated view of their company’s worth, while others lack a knowledgeable basis to evaluate their company. A third party can provide insight on what values drive the business, as well as its strong and weak points.
Ideally you want three to five years of solid earnings and revenue growth. “If you are pretty sure you can add a couple more years of good growth [before selling], recognize you are also risking the possibility of the numbers dropping off,” Olson says. Investment bankers and business brokers usually base this on a multiple of cash flow and earnings before interest, taxes, depreciation and amortization (EBITDA).
One of the biggest mistakes sellers make is not preparing sufficiently. “Many times, people will spend more time preparing for the sale of their home rather than the sale of their business,” Russell says. “When you are trying to sell your home, you get a good realtor. You do everything you can to get it into good condition so that people will want to see it. You get your paperwork in order and expect there will be an inspection. During a business sale, sellers seem to think people will appreciate their business just the way it is as opposed to improving it prior to sale.”
Increasing revenue and decreasing expenses are important elements of preparing a business for sale. But it’s not wise to squeeze more profit by, say, firing a few salespeople if, in the long run, it’s in the best interest of the business to keep them employed, Olson cautions. A smart buyer will see through that tactic. “If the roof needs fixing, fix the roof,” he says. “Don’t avoid it just because you don’t want to show that on the books. It is penny wise, pound foolish.”
Instead, look to make operations and marketing improvements to help the business:
- Clean up inventory. Make sure there are no receivables on the balance sheet.
- Have an intellectual property audit to see what trademarks, patents and other intellectual property are owned, which can drive up the purchase price.
- Downsize unnecessary expenses, like a company car, that inflate business expenditures.
Also consider what the buyer is willing to purchase. Some buyers may be interested only in business assets, not the company as a whole. Or if a company is involved in more than one business, buyers may only be interested in the core business. If, for example, an owner is in the business of making an agricultural product but also has a cattle raising business, he or she can spin off and sell the latter to streamline the company.
Business owners should look at projections and financial statements for a three- to five-year range. What does the cash flow look like? Owners may need to normalize their financial statements if family members exceed typical market-rate salaries or have amenities like a company car that may need to be re-evaluated. Inventory should be fresh, and receivables should not be on the balance sheet.
It’s important to ensure all operating licenses and permits are in order, as well as conclude as much outstanding litigation as possible – eliminating questions, concerns and bargaining tools for the prospective buyer. If buyers will purchase real estate as part of the transaction, they’ll likely want verification that there are no environmental issues. Therefore, environmental documentation should be available, Barron says, and any outstanding environmental issues should be resolved as expeditiously as possible.
Sometimes the buyers willing to pay the most for a business are competitors. Due diligence is paramount. Competitors interested in the business should be asked to sign a nondisclosure agreement prohibiting them from using the information provided during negotiations against your company. They should be given only basic financial information sufficient for negotiations; if they are interested in buying the company, they should draft a letter of intent in the form of a nonbinding legal document that lays out the terms of the negotiations.
“The trick is to not give competitors so much information that they can use it against you,” Olson says. “I’ve seen it happen where competitors say they need to see profit margins and where a company is getting its materials. Then they turn around and say, ‘We are really not interested in buying you,’ and use it against you. That’s where an investment banker helps draw the line.”
Other times, owners sell to the management team. But often that group doesn’t have access to money to put together a competitive bid. Management may make an offer to buy 60%, with the original owner controlling the remaining 40%, and promise to buy out the remainder later. Agreeing to this often is a mistake, Olson says, because it leaves a former founder as a minority stock owner and powerless to make decisions, which can quickly turn friends into enemies.
Remember it’s extremely difficult to keep a potential sale a secret. “It’s a mistake to lie to people,” Olson says. “Sooner or later, people will know you were lying to them, and when you lie to a customer or an employee, you lose all credibility.” Instead, owners should be prepared with an accurate but not too detailed response about how they are planning for the future.
Regardless of whether the business is sold or passed down, it’s always important to prepare and plan for the future – now more than ever. As financial lending finds resurgence, the door is opening to possibilities that up until now simply haven’t been available.