exit planning for privately held businesses – tradition or monetary value? may 12, 2006 2006...

Exit Planning for Privately Held Businesses – Tradition or

Monetary Value?

May 12, 20062006 Estate & Business Planning Program

By Bill EastwoodDoering, van den Heever & Eastwood Ltd

Offices in Fort Collins and Greeley, ColoradoTel (970) 346-3950

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Outline of Exit Planning Alternatives

1. Owner’s Alternatives

2. Outside World

3. Case Studies

4. What is Value?

5. Analysis of Alternatives

6. Overview of the Current M&A Market

7. Preparing a Business for Sale

8. Marketing the Business

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The Owner’s Alternatives

Family succession Sell the business to management team

Leveraged buyout ESOP

Merge the business with a competitor and retain equity

Sell to a third party Strategic buyer – in the business – regional bank

buys a community bank

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The Owner’s Alternatives

Sell to a financial buyer – private equity (leveraged buyout), unparalleled funds available

Sale of less than 100% - recapitalization Initial public offering for larger businesses –

Cabela’s

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The Outside World

Global economy “Walmartization” Scarcity of oil and basic resources Growth of developing countries General economic prosperity U.S. service based economy Sustained real estate inflation

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The Outside World

Private equity and hedge funds with $100’s of billions to leverage and invest in middle market businesses

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Making Correct Exit Decisions

When is the correct time to develop an exit plan?

Which of the exit alternatives are feasible for the business?

Do I need an advisor team? What is my business worth?

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Making Correct Exit Decisions

Does continued family ownership make sense?

What value can I obtain by selling to management?

What type of third party buyers would be interested in my business?

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Case Study #1 – Cattle Rancher Whose Land Became Valuable

Note: All case studies are fictitious. In each case, the owners are your clients. They have asked your advice.

Joe Helerick sat back in his chair on his 20,000 acre ranch in Sand Hill country, Nebraska reflecting on an offer to buy his ranch.

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Case Study #1 – Cattle Rancher

He was the 4th generation family of a family who had owned and run a successful cow/calf operation.

There had been a number of difficult times but he now had 400 mother cows and had been able to make a good living.

The ranch had paid to educate his two children, Jack, age 34, a lawyer in Houston, and Jessica, a dentist in Lincoln, NE.

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Case Study #1– Cattle Rancher

Joe’s wife, Sandra, was tired of looking after the cattle, particularly during cold winter stretches like the one they were presently experiencing.

The Helericks did have a condominium in Lincoln and had a time share in Hawaii to enable them to get away.

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Case Study #1– Cattle Rancher

Running through the ranch was a “gold medal” fishing stream where the Helericks had been able to supplement their income through fishing leases that now amounted to $50,000+ per year.

The offer for the ranch was $21 million by a group of West coast real estate developers who wanted to build a golf course.

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Case Study #1 – Cattle Rancher

Joe had had many offers before, but never one this tempting.

Although in good health at age 63, Joe knew that sometime in the future he would have to decide what to do with the ranch.

Both Jessica and Jack wanted him to keep the ranch, but had no interest in returning or assisting in the maintenance.

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Case Study #2 – The Impressive Software Co.

Jack Calvert of Lincoln, Nebraska, had a critical decision to make. At age 70, he had to decide what to do with his computer software company that made specialized software for the oil and gas industry.

The company had been very successful and Chuck MacIntire, age 49, had managed the business for a number of years without any real day-to-day management assistance from Jack.

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Case Study #2 – Software Co.

Jack had been instrumental in helping make several add-on acquisitions.

Sales of $11 million generated $2.7 million of EBITDA for 2005.

Jack had received numerous offers over the years to buy the business.

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He had received numerous calls from investment bankers telling him of the advantages of selling to the employees with a private equity group owning a large part of the business and the management owning a minority stake.

Other investment bankers had wanted to have an auction to sell the property to the absolutely the highest bidder without any consideration for the 40 employees, many of whom had worked at the business for many years.

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Jack now spent 3-4 months of the year hunting and fishing with a little golf in between his home in Hawaii, his condo in Cabo San Lucas, and an elegant home in Lincoln, Nebraska.

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Neither of his children, Jill nor Bill, were interested in the software business and were well taken care of from his estate through other means.

Jack was an avid University of Nebraska football fan and had attended every game for the last 7 years (even in 2004).

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Jack talked to an investment banker friend of his regarding valuation of the company.

The banker placed a preliminary valuation of $17-22 million on the business that had been growing 8-10% annually.

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Jack sat down with the key management people at the company.

He asked them if they were interested in buying the business. They said that they were very interested in buying the business.

He also broached the idea of a private equity firm taking most of the risk and management owning a minority position.

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Jack also discussed the opportunity to sell to a large software company where the best programmers would have opportunities outside his company.

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Case Study #3 – The Wishful 3rd Generation Community Grocery Store Owner

Rick Hayworth, age 67, was a third generation independent grocery store owner in Crete, Nebraska.

He had operated the business for 25 years and was in good health.

Two years ago he had turned the day-to-day operations of the business over to his son George.

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Case Study #3 – Grocery Store Owner

George, age 44, had two ambitious sons who also worked in the business.

They had recently moved their store to a new 25,000 sq. ft. modern grocery store with deli, bakery, pharmacy, “all the things that bigger stores had.”

His store was supplied by a national food cooperative to keep the business competitive.

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Rick was evaluating an offer he had recently received from Safeway, a national grocery chain.

Because Crete was a fast growing community and the wishful grocery store met its specifications, Safeway wanted to have a good footprint in the location (population now 7,000) without having to compete head to head with the community grocery store.

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Hayworth was also contemplating an offer to buy two other independent grocery stores in adjoining towns, that were being sold by another independent grocer who was retiring, for George’s sons to manage.

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Case Study #4 – The CNC Machine Company Co.

Dave MacIntosh and his two brothers, Tom and Mike, were contemplating what to do with their business.

The business had grown to almost $20 million in annual sales with profits exceeding $5 million per year.

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Case Study #4 – CNC Co.

They made medical components, triggers for air bags, computer disc drives, defense contractor parts and other specialty components.

The Computer Numeric Control Machines (“CNC”) (patterned on Swiss watch technology) were one of the fastest growing manufacturing machines in the world.

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Because the machine could make up to 50 different cuts on one component (none larger than your hand).

Once the machine was configured, it was reliable and could run lights out 24/7.

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Dave, at age 44, knew that the market was excellent for his business.

An investment banking firm had advised them that they should explore exiting the business due to increased threat of foreign competition.

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Their mother, age 66, owned one-fourth of the company.

She had kept the company and the family together during very difficult times when their father had died 15 years ago at the age of 49.

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Case Study #5 – The Case of the Successful Cabinet Maker Who Waited Too Long

Joe Seamster had been very successful making customized cabinets for regional home and commercial builders.

His operation was efficient enough to sell quantities to the large box stores (Lowes, Home Depot) to keep his production lines moving smoothly during the slow periods even though his margins were much less.

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Case Study #5 – Cabinet Maker

Joe, at age 65, had completed a major plant expansion to take care of the booming real estate market in Lincoln in 2005.

The company had spent $3.5 million ($2.5 million financed by an industrial revenue bond) and had also added over another $1.0 million in equipment.

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The business currently made about $2.0 million a year on sales of 18 million.

Twelve months ago, Joe, a heavy smoker, found out that he had lung cancer. He had fought valiantly. Recently he was informed that he had less than 3 months to live.

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Joe had an excellent general manager who was capable of running the business.

His wife, Josephine, knew nothing about business and was totally reliant upon all of Joe’s decisions.

Their two children, Steve and Dick, were both trying to find their way in life and lived in Boulder, CO. To date they had shown no interest in the business.

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What is Value?

Value is measured differently by each buyer or owner

Not all value = $ Social, Ethical, Moral, Religious, Sentimental,

Economic and Commercial Value Emotion Legacy People factor

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What is Value?

Going Concern Value Fair Market Value = $$$$

Capitalization of Earnings Discounted Cash Flows Market Approach

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Family Succession

Often emotional attachment to business Usually owner carries note Not usually the best way to maximize

financial value Usually results in ongoing risk to seller

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Family Succession

Hard questions Does the next generation have the ability and

desire (passion) to successfully manage? Can the business compete effectively in present

environment? Need to grow Need to sell to a larger strategic competitor or

orderly liquidation Need to diversify

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ESOP (Employee Stock Ownership Plan)

Enables employees to acquire beneficial ownership in their Company without having to invest their own money

Advantage of the ESOP is that employees are able to acquire this stock without paying a current income tax on the stock

The advantage to the Company is that the ESOP makes pre-tax dollars available to finance Company growth and/or to create ownership liquidity at the time of retirement

Owner has tax advantages on sale proceeds

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Recaps & Mergers Management leveraged buyout

Feasibility and cash flow business Partial sale or recapitalization?

Sale of majority or minority stake Leverage the business Risk of ongoing ownership New partners

Merger Usually paid in stock of merged entity Liquidity event dependant on future success of merged

entity

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Outright Sale

Individual (small deals < $3 million) Strategic/synergistic buyer (all sizes) Financial buyer > $3 million or larger

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Robust M&A Market

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Robust M&A Market

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2005 Value Multiples

Annual Revenue Medium Multiple (EBITDA)

$ 50 Million - $200 Million 8.2

$20 - $50 Million 6.8

$10 - $20 Million 6.4

Under $10 Million 5.4

Source: IMAP 2005 Pricing Survey Results. IMAP members around the world advised on 220 transactions with $4.079 billion in valuations.

All Manufacturing Companies by Revenue (North America)

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Structure of the Deal Affects Value

Currency Cash is king Seller financing brings higher price

Particularly on deals valued under $25 million Stock swap — tax deferral and liquidity consideration,

negative stock market risks

Stock or asset sale

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Value of Privately Owned Businesses

Factors that differentiate an 8x+ multiple business from a 3x (an “A” business from a “C” business): Industry (growth vs. stagnant) Size (Scalability) Growth in sales (speed to acquire opportunity) Earnings — growth, quality and consistency Balance sheet strength Perceived competitive advantage — brands, patents,

technology, costs Margin as percent of sales Strength and continuity of management

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Value of Privately Owned Businesses

Exceptions to the 3 to 8 EBIT rule: Each buyer will have a different criteria for

valuation Some buyers and industries use EBITDA rather

than EBIT Examples:

Private equity firms evaluate based on projected ROE Food brand purchaser may project savings in costs from

adding a brand to its existing distribution system Cable company businesses sold on a value per

subscriber

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Who Are The Buyers? Strategic / Synergistic Buyers

Strategic / Synergistic Buyers A buyer in the same business or industry as the seller

Consolidating industry or segment Economies of scale Expansion of product line or service Acquisition of clients or technology

Often pay price based on their own ROA or ROI multiples May pay large premium if they feel it will give them major

competitive advantage. Often make acquisitions to prevent any other competitor from

owning company - defensive.

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Who Are The Buyers?Financial Buyers

Private Equity funds raised over $1 trillion from 1997-2005 Hundreds of billions left for investment April 2006 – KKR completed public offering of $5.5 billion Barron’s April 24 estimated Middle East 2005 investment of

$118-120 billion Thousands of buyout funds with billions in capital can

generally borrow 1-3 times equity to buy a company

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PE – Funds Available To Invest

Private Equity Appetite: Money Looking for Work Average PE fund has approximately 53% of its committed capital invested New fundraising activity has continued to grow in 2006

1996 ‘ 1997 1998 1999 2000 2001 2002 2003 2004

Source: : Thomson Financial & Robert W. Baird

2005

98.6

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Who Are The Buyers?Financial Buyers

Financial buyers — “private equity funds & leverage buyout groups”

Use equity provided by institutions, pension funds, insurance companies and other investors

Borrow money to increase the return WACC (weighted average cost of capital) Leverage is cheap and tax deductible but cost is increasing

Looking for a return on Investment (ROI) Large pools of funds to invest

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Financial Buyers

Not hands on managers (manage money, not companies)

Many different types of buyout funds Each has a profile of types of investments pursued by size

and industry

Some look to consolidate a niche industry Almost all have a limited ownership time horizon (5 years

average) to sell the company

Most encourage management to own part of the company (5% — 20%) (vested interest)

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Financial Buyers

Look for 25% — 35% Return on Equity Have different minimum earning thresholds EBITDA of $3 million - $50+ million Most may consider even smaller “add-ons” that

complement an existing business

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Who Are The Buyers? Private Investors

Local entrepreneur buying a business to own an asset that they manage and control

Often buying a job Looking for insulation from employer Deal Size is usually an issue Financing sources limited – banks, leasing

companies & seller finance Buyer often does not understand the risks or price Seller usually overestimates the value (emotional)

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The Marketing Process

Prepare Business for Sale Dressing up prior to sales effort Maintain management continuity Utilize pass through entity (Sub S, LLC) Identify and resolve litigation, intellectual property,

environmental and other contingent liabilities Determine reliance on key customers or suppliers Identify personnel issues Obtain audited financial statements

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Offering for Sale The team is critical – lawyer, accountant, trusted financial

adviser, and investment banker Determine advisability of a M&A professional If M&A professional desirable, evaluation and choice is

critical – make sure that there is a good fit with management and owners.

Cost of M&A representation = 2% - 5% of deal value

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Business Sales Strategy Prepare a Business Summary or Offering Memorandum

and Teaser Identify potential buyers Open negotiation process:

With one purchaser at a time To a few prospects (“Selective Marketing”) With a controlled auction to all qualified prospects

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Major Legal Documentation Confidentiality agreement Letter of intent Due diligence Definitive agreement and closing

Management must concentrate on running the business

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When Should A Business Be Sold?

Objectively Analyze Business’s Sales Prospects When the business Is performing well When there are good prospective buyers able to act within

a reasonable time When the owner is committed to spending the time and

money to market the business properly When the condition of financial records are sound

Are the financial statements audited? Possibility of restatement in due diligence? Entity profitability is healthy Cash flow is strong

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When Should A Business Be Sold?

When contingent liabilities are limited and estimable Warranty claims, environmental, employee issues, litigation

Owners start to lose the passion for continued growth and progress. If you are not passionate about the business, your entity

value is probably stagnant Management team has been groomed to run and grow the

business

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Timing Your Transaction

“Better to sell too early than too late, but pretty nice to sell on time”

Schedule your transaction by your company’s timetable, not “the market”24 to 36 months in advance (“Maybe”)12 months in advance (“Probably”)Pulling together your team (“Go”)

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Why Deals Do Not Get Done

Source: Baird 2005 US Middle-Market Private Equity survey

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Conclusions

Successful businesses are marketable Business transfer is a marathon, not a sprint Seller must be realistic about price and timing Having a trusted team is critical Do not ignore running the business

If business falters, all else is lost

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Case Study Discussion

exit planning for privately held businesses – tradition or monetary value? may 12, 2006 2006...

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