For a Successful Exit, Build Value From the Start
Originally published: 09.01.11 by
Kevin R. Yeanoplos
Part 1 of 3 on how to value a business, sell your business, or buy a business.
Borrowing from noted “business adviser” Norm “Normie” Peterson, “It’s a dog eat dog world out there — and I’m wearing Milk-Bone underwear.” With a volatile economy, growing competition, and increasingly demanding customers, business owners can’t seem to catch a break. But the astute entrepreneur looks at the lemons, and starts building a lemonade stand.
By understanding the various factors that drive a company’s value and making a few simple changes, owners can make the most of the current opportunity for growth and squeeze every last dollar of value out of their businesses.
In this three-part series, we will explore the creation and maximization of the value of a closely held business.
Selling Plans Should Start Early
Any discussion of increasing value has to begin with an understanding of what value is and isn’t. To begin, let’s consider some sobering truths.
I regularly ask business owners the following question: “What is your greatest financial asset?” Too often I’m greeted with blank stares. These owners run their businesses without regard to creating value, which ultimately will benefit them when they sell
the companies. But the most important time to plan on getting out of a business is when you’re getting in. Thinking frequently of how and when to leave a business from the very beginning forces owners to look more carefully into the future and make sure their everyday decisions are creating value.
Entrepreneurs should consider different exit strategies at the inception of a new business. Remember that the exit from the business is the payoff for the years of financial risk, sleepless nights, family birthdays on the road, and other unpleasantness. Don’t put off thinking about exiting the business until you are ready to retire. The most important thing for an owner to have is a clear vision of their ultimate objectives from the very beginning.
But now for the good news: If you’re not one of those rare prophetic owners, it’s never too late to make changes. 3 Keys to a Success Exit Strategy
A successful exit strategy should revolve around three primary objectives: maximizing value, minimizing taxes, and optimizing timing.
1. Maximizing Value
Value is something that is intrinsically desirable. Maximizing the value of a business often revolves around positively impacting other people’s perceptions of the business, so that they find it intrinsically desirable.
A business owner should know and understand indicators of high value and low value. For instance, indicators of high value include high and sustainable cash flow, room for the business to grow, and low failure rates for the industry in which the business operates. Indicators of low value include heavy reliance on the existing owner for sales/revenue, few assets, and concentration of revenue from only a few customers.
The value of a business is generally determined under three different approaches to value: the asset approach, the market approach, and the income approach.
• Asset approach: The asset approach is based on the economic principle of “substitution,” which states that the economic value of a thing tends to be determined by the cost of acquiring an equally desirable substitute. In this approach, all of the assets and liabilities are adjusted to reflect their value, including intangible assets if any (assets that can’t be touched or seen, such as goodwill). The value of the company will be the value of the assets less the value of the liabilities.
• Market approach: The market approach is based on the economic principle of “efficient markets.” In this approach, the value of a company is estimated by comparing it to similar businesses that have been sold in an established market place.
There are a number of methods within the market approach, including the identification and analysis of comparable publicly traded companies, actual sales of similar privately held companies, and past transactions in the shares of the company itself.
• Income approach: The income approach is based upon the economic principle of “anticipation” (sometimes called the principle of “expectation”). In this approach, the value of a company is the present value of any future economic income (usually cash flow) expected to be generated by the investment.
As the economic principle implies, the investor “anticipates” the “expected” cash flow to be earned from the company. This expectation of prospective economic income is converted to a present worth — that is, the indicated value of the subject business interest.
There are numerous methods that make up the income approach, including capitalization of earnings, capitalization of dividends, capitalization of excess earnings, discounted future earnings, and discounted free cash flow.
All three approaches are generally considered for every valuation, although they may not ultimately be used. Regardless of the approach used, there are several important areas to consider as part of a thorough analysis, including the following:
• Level of sales and profit margin. Is it a business with smaller sales volume and a higher margin, or one with higher sales where operations may allow for improvement and/or growth?
• Financial strength. Does the company have undervalued assets? Are there inventories that can be used as collateral for financing? How much pre-acquisition leverage is acceptable?
• Geographic location. Where is it located? Is it the only acceptable location? Will efficiencies of scale materialize only if the target is within a certain area?
• Purchase price, financing terms. How much is budgeted? What is the seller’s financing? Is an earn-out provided for? What financing resources are available? How much value is perceived in the eyes of the lender?
• Management strengths and weaknesses. Will current management stay? Are there specific management strengths not present?
• Market and market strategy. Is the buyer hoping to acquire a particular segment of the market by buying the company?
• History and reputation. Is the company a family business? Will it be difficult to persuade the key employees to remain?
• Property, plant and equipment. Are assets at or under capacity? Has the equipment been well maintained? Is it paid for?
• Liability issues. Are there identifiable or contingent liabilities? Are there proposed changes in safety or environmental regulations that affect the industry? Will the company have difficulty complying?
• Industry and type of company. What bearing does product selection have on profitability and growth? Is the business cyclical and what is the competition like? Would it be easier for a buyer to purchase or start the business from scratch? Are they buying your job or a business? What have other similar businesses been sold for in the past?
2. Tax Minimization
The “tax monster” can take a huge bite unless the exit is effectively structured. Minimizing taxes in an exit strategy begins with selecting the best entity structure.
When considering an exit strategy, there are certain distinct tax advantages to selecting a “pass-through” entity structure, such as an S-corporation, limited liability company, or partnership. For instance, the small business owner is typically subject to a lower overall effective income tax rate when exiting these types of entities.
Serious consideration of a business exit should include strategies that are significantly tax favorable. As the name implies, tax-free split ups, tax-free spin offs, and tax-free exchanges all offer tremendous potential tax saving advantages to the business owner.
In addition, selling all or part of the company to an Employee Stock Ownership Plan (“ESOP”) should be considered as it enables the owner to keep the business in the “company family” while converting ownership to liquid assets.
3. Optimizing Timing
The best time for an exit is when the business owner wants to — not when they have to. Decide when you want to exit, and then plan accordingly.
Part 2 Preview
Now that we understand what value is and the factors that impact it, it’s time to take a look at what we can do to increase it. Part 2 of the series will explore some specific ways of maximizing the value of a closely held business.
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