Takeaway: Too many business owners view their business sale and their retirement as a simultaneous event and end up delaying the sale to the day they want to stop working. That mis-perception can be very costly.
The Baby Boomers are retiring in large numbers and according to New Economy Week, over the next ten years Trillions of Dollars of businesses will be changing hands. The number of businesses that change hands will very closely mirror the number of baby boomers that are retiring.
Price Waterhouse reported in a Trendsetter Barometer Survey of Business Owners that 51% were planning on selling their company to another company compared with 18% anticipating passing on the business to a family member and 14% planning a sale to the company's management.
The trends point to more than a doubling in the number of businesses that will hit the market looking for a buyer by 2020. Simple economics and supply and demand would suggest that unless the number of buyers increases significantly, there will be an erosion in valuations for business sellers during this rush to the exits. Compare that to the relatively robust environment business sellers have enjoyed over the past 3 years. This period was supported by unprecedented Private Equity investments, in addition to the available cash from corporations with rising profits, and very favorable interest rates.
Given this backdrop, what is a business owner who is anticipating selling his business in 2020, to do? Move up your sale time frame, buttake your chips off the table with a sale transaction sooner rather than later. Your eventual exit could be in 2020 after working full time for the new owner for 1 year to transition customer relationships and intellectual property, followed by a limited consulting engagement for two years.
Too many business owners view their business sale and their retirement as a simultaneous event and end up delaying the sale to the day they want to stop working. That mis perception can be very costly. Too many owners wait too long and end up selling because of a negative event like a health issue, loss of a major account, a shift in the competitive landscape, or just plain burn out. As you can see, none of these major reasons for selling puts you in a favorable negotiating position. As a general rule, the faster you want to disassociate yourself from your business, the more the buyer will want to deduct from his purchase price. Your desire to leave quickly is a red flag of risk to the new owner.
Your best outcome is to sell your business near the top and stay involved as an employee or consultant for a reasonable period. If you look at the transaction structures that are popular in the acquisition of closely held businesses, this approach makes a lot of sense. The more a business depends on the owner for its success, the greater the risk to the buyer. The greater the percentage of a selling company's projected earnings that is dependent on future new sales, the lower percentage of transaction value that the seller will receive as cash at closing. The greater the concentration of company sales to a small number of customers, the lower the price and the greater the earn-out component of transaction value.
Most privately held family businesses have one or a combination of these value detractors. Your selling strategy can mitigate the negative impact on selling price. By exiting before the necessity of exiting, your sales trajectory will more than likely be on the increase than on the decline. Buyers pay a premium for growth and discount for flat or falling sales. Unless your entire revenue stream is contractually committed over the next several years, most buyers will introduce an earn-out as a component of the total transaction value. This is a risk avoidance strategy that ties the total acquisition price to the future performance of the business post acquisition. It is also designed to keep the business seller engaged in the near term performance of the business.
In spite of the normal response from business sellers who want the entire sale price in cash at close, we believe that under the proper circumstances and properly memorialized in the definitive purchase agreement, earn-outs can be a big win for a seller. We normally try to tie the earn-out to future revenues of the acquired property. That is usually very easy to measure and to audit if necessary. Earn-outs based on future EBITDA or division profitability are more problematic because of the greater possibility for interpretation by the buyer. You all of a sudden get an accounting entry of corporate overhead in your financial reconciliation and your profit disappears.
Count on your original champion who negotiated your agreement not being involved by the end of the earn-out period. Make the agreement air tight in terms of how it is interpreted. A subtlety that we negotiated into an earn-out for a client was that the earn-out would be paid based on the greater of the sales price for the seller's product or 80% of list price, whichever was greater. You see, we cannot control how the buyer runs the business once he has the keys, but we can control how the earn-out is calculated. This prevented the buying company using the seller's product as a loss leader in combination with their other products and shifting the revenue to other products at the seller's expense.
If you look at this preferred structure in conjunction with your sell now, exit later strategy, it can work in your favor. Wouldn't you want to be fully engaged and energized during your earn-out period and drive the value of the earn-out? As part of the new company, you now have 325 installed accounts instead of 25. Your sales force is now 25 strong compared to 2 sales people from your prior company. Your advertising budget is twenty times your old budget. You now have a network of 50 manufacturers reps supporting sales. Your new company's access to growth capital dwarfs what was available to your little company. Do you think you have an environment where you can achieve a sales growth far greater than what you could do on your own? The key is to negotiate the earn-out that gets you to a transaction value comparable with an all cash at close offer that assumes your company sales grow at their historical rate.
For example, your offer if you back the buyer into the all cash at close offer is $5 million. Compare that to a deal that would provide you $3.5 million at close and another $1.5 million in earn-out if sales grew at 10% per year (your company's historical rate) for the next three years. Our contention is that the earn-out deal could be far superior. Given the much greater distribution power of the new owner, you could reasonably expect sales to jump by 25% per year, driving your earn-out to $2.5 million and resulting in a $1 million improvement in transaction value. You want to be fully engaged to achieve this result and that is exactly what the buyer wants.
As a business seller you have many factors that can greatly impact your selling price. Getting multiple buyers involved is probably number 1. A very close second, in the near term future is the timing of your sale. The economic trends are against you postponing the sale part of your exit. You can always sell now and retire later.Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of lower middle market companies. For more information about exit planning and selling a business, click to subscribe to our free newsletter The Exit Strategist