By Dana Holmes, Jim Ward and Rusty Kruciak
One partner decides to buy out the other; this scenario is often the first, instinctive reaction when owners reach different stages in life or develop differing priorities. But while it may seem like the quick, easy solution, a buyout may not be in the long-term best interest of either party.
In this first installment of the “Exit Planning Corner,” we share an example in which savvy business owners, who were initially considering a buyout, increased the real value of their business as a result of the exit planning process — what we call value acceleration. Read more to learn how the process also helped each of them achieve the results he desired and significantly improved their financial outcomes.
Bill and Tom founded a highly profitable business together and operated it as partners for a number of years. Although the working relationship was strong, both had always taken the same compensation from the business and, over time, developed different perspectives on risk and growth. Bill was intimately involved with the sales side of the business, and he saw opportunities for the business to expand significantly. Tom, on the other hand, was content to focus on stability and income. He was not motivated to take the risk of investing in capacity, either in the form of additional debt or a reduction in their personal income for some period.
When we at 2nd Generation Capital were hired to value the business, Bill was considering making an offer to buy out Tom. As we began exploring options with Bill and Tom, the exit planning process provided a basis for discussions that led them to evaluate the situation strategically. They drew the following conclusions:
The achievable value of the business was constrained by its limited growth. Although the business had strong profit margins, a prospective buyer would not see its true potential. Analysis also indicated that the customer concentration was high because Bill and Tom had not focused on developing new customer relationships for some years. Customer concentration is another factor that can limit perceived value to a buyer due to greater perceived risk.
The low growth and 50/50 nature of their partnership had resulted in neither partner grooming a successor. The scale of the business was easily manageable for them, and neither wanted to risk the creation of divided loyalty among key staff. For this same reason, they had chosen not to employ any family members. This concentration of management experience between the only two owners also impacted value negatively, as it implied that value was too dependent on their personal goodwill; thus the business would be hard to transfer.
Our market-based analysis of value indicated that their company would be viewed on the lower end of a market range of multiples that varied between 4X and 8X free cash flow. Both men agreed that 4X was not a price that would induce Tom to sell out. After a rigorous exit planning process facilitated by 2ndG, the partners decided to pursue the following course of action.
Bill sold his 50 percent share of their building to the more-conservative Tom. Two-thirds of the purchase price was funded by a mortgage, to be repaid by the existing rent from the company, and provided growth capital for the expansion in equipment and personnel that was needed to increase growth and decrease customer concentration. Tom also paid the remaining third in the form of 10 percent of the equity of the company, thus incentivizing Bill, by giving him control and the ability to earn a bigger piece of the exit value. Tom’s risk was reduced, as he had the stable asset of the building and a known market value, but he was still incentivized to focus operations to maintain or grow the value of his 40 percent equity. The men agreed to maintain their existing split of compensation.
Bill added some key staff, promoted two long-term employees into successor roles, increased output capacity through capital investment, and sold all of the increased capacity to new customers. The revenue of the business increased as a result of all of these actions, and its risk profile was reduced. When they sold the business four years later, the market transaction brought a higher-range multiple of the much higher cash flow.
By taking time to analyze their business from the perspective of an exit plan, these partners addressed differences that could have caused disruption in their partnership. And, as a result of the process, they took action that allowed them to realize a higher value for the business, even though the exit occurred many years later.
These business owners were able to accomplish a successful exit because they were focused on value acceleration. A smart business owner does not put off exit planning until he/she is approaching retirement age. Good exit planning is really good business strategy – thinking through the elements that drive business value and focusing strategic planning on these elements.
Consequently, the business value is maximized at any point in time when circumstances turn the owner’s focus toward an exit.
Read the related article “Exit planning: How mindful business owners accelerate value” which provides an overview of the exit planning process.
Going forward, we anticipate that future articles will provide additional case studies as well as focus on key concepts that may be unfamiliar to some business owners. We encourage you to follow the topics by signing up for KraftCPAs quarterly magazine or email alerts. Please reach out to us with your questions.