Part 2 of this series explored the numerous financial and non-financial objectives an owner may have when pursuing the sale of their business. Today’s edition will discuss the possible conflict between objectives and help an owner determine what to do if the most logical buyer for one goal is in conflict with another.
Most business owners are pro-small business, and if they’re being honest with themselves will say that they’d love to see their legacy carried forward by another individual who can grow the business and reap the same rewards as the seller has throughout his or her career. In today’s environment, however, it’s rare that an individual is able to make the best financial offer, and the valuation gap between individuals and corporations or private equity investors can be massive.
That doesn’t mean that selling to an individual precludes the owner from netting enough from the sale to achieve whatever financial goals he has set forth. Making this determination requires a strong evaluation of the business to determine the valuation an independent buyer would place on the business today, and a subsequent analysis of the owner’s personal balance sheet and ability to achieve certain goals upon a liquidity event. It’s entirely possible that this lower valuation still enables the seller to achieve full financial freedom, and in such a case it may not matter that the buyer isn’t paying the highest price.
If, however, the analysis suggests that the owner will come up short, a reset is required. An owner first needs to understand the underlying reasons for the valuation gap and the steps required to close it. Then, the owner has a choice – create and execute on a value building strategy to position the business to be sold to an independent buyer at a higher price, or reframe expectations. Reframing expectations may be as simple as delaying the sale. Consider an owner making $800,000 per year with a business that is worth $5,000,000. If the owner continues working for five more years, she will make $4,000,000 over that period. Even if her valuation declines, and after five years she sells for $3,500,000 instead of $5,000,000, the sum of her annual income and proceeds from the sale is greater than the proceeds from a sale today. Further, by earning income for five more years she has not only continued to save (hopefully) but also delayed drawing on her retirement savings, making her better positioned to enter retirement.
Reframing expectations may also mean finding other buyers willing to make more generous offers. This typically involves engaging strategic or private equity buyers who represent a very different reality. The business becomes part of a much larger entity, and the owner’s legacy is that of someone who built a business large enough and attractive enough to warrant such an investment. This is an oft-overlooked aspect of legacy – most businesses are not big enough or profitable enough to interest a strategic or private equity buyer, so the mere existence of this opportunity suggests the owner has accomplished something great.
Selling to a strategic buyer can yield several unique rewards in addition to the higher purchase price. Owners who actively manage operations and/or work directly with clients or customers are oftentimes required to continue working in the business for several years after the sale. Many owners love their work but feel burnt out from the stress of ownership, and this enables them to focus exclusively on what they love doing.
Continuing to work in the business means the seller also receives a comfortable salary and improved benefits. Compare the sum of the purchase price and the owner’s income during his years as an employee to alternative scenarios and you likely have a much more lucrative transaction.
Further, strategic buyers can offer staff benefits that no independent owner can match. Health insurance and retirement savings plans are made available to all full-time employees, and they are almost always better plans than the independent owner provided (if benefits were provided at all). Larger companies can also offer opportunities to advance and grow within the organization, providing the flexibility and upward mobility absent in small businesses.
Selling to a private equity buyer may offer an even greater financial reward if the company is the buyer’s first investment into its industry (known as a platform investment), because the seller will likely retain some equity in the company. Private equity buyers typically plan to own companies for 5-7 years and then sell them. The former owner who retained equity would cash out alongside the private equity firm at this point, effectively enabling them to sell their business twice. If the firm accomplishes its stated objective, namely to double or triple the size of the company during this time, then the original owner pockets considerably more than he or she would under any other scenario.
Private equity has grown rapidly in the past 5 years, with an explosion of new firms focused on lower middle market companies (typically defined as companies with $1-5M of EBITDA). Many search funds target even smaller companies, investing in businesses with as little as $500,000 of EBITDA. As opposed to a traditional private equity firm that seeks to invest in a broad portfolio of companies, search funds are investment vehicles through which investors financially support an entrepreneur's efforts to locate, acquire, manage, and grow a privately held company. They are an ideal solution for owners of smaller businesses who want to retire and do not have an internal succession plan.
The point is, selling to a strategic or private equity buyer produces a very different type of legacy, but a legacy is still created. Regardless, owners who face a conflict between the best financial and non-financial buyer can resolve their issues with proper planning.
In the final part of this series, we’ll attempt to tie everything together by discussing the three things every owner should do before attempting to sell.