By John T. Carter
The primary goal of business owners is to “cash in their chips” and retire from their businesses on their terms. Ideally, this includes selling to a larger company for a huge windfall or transferring the ownership to an existing owner, the key employees or business-active children. The problem is that most contractors and other small business owners don’t prepare their businesses for this all-important, once-in-a-lifetime event. Instead, they roll the dice and hope that the chips will fall in their favor. Unfortunately, most of these transfers are unsuccessful and result in seller’s remorse.
The question is: How do contractors and other business owners prepare for the successful sale or transition of their businesses, and when should they begin the process?
The answer is: Owners need to create and build transferable value in their companies and create an exit plan that accomplishes their goals at least two to three years from their targeted exit date.
Building transferrable value
Regardless of whether an owner plans to sell the business to another contractor or competitor, or transfer the ownership to the other co-owner, key employees or business-active children, it’s critical that the business can operate at a high level without the owner’s ongoing involvement. By creating a self-sustainable company, the business’s real inherent value – as a cash flow machine – can be replicable and transferrable to the targeted successor.
Creating transferrable value, which is converted to dollars upon the sale or transfer of the business, results from the implementation and ongoing support of the following value drivers. Each value driver works independently to increase the likelihood that the business can continue to grow, improve market share and increase cash flow after the owner’s departure.
Value Driver #1
The first and most important value driver is the development of a well-trained and motivated successor management team. The team should be composed of key employees who are responsible for setting the company’s objectives; monitoring activities and company performance; and managing and mentoring the other employees. Each team member brings unique skill sets and, collectively, they work together to build a championship organization. Buyers and targeted successors (perhaps the key employees) will pay a huge premium for a strong successor management team that has a proven track record. Likewise, failing to identify, train or motivate a successor management team gives the buyer or successor the sense that the owner has been running a “one-person band” that can’t be sustained after the owner leaves.
Value Driver #2
The second critical value driver is having documented and applicable operating systems that can create reoccurring revenue and help the company weather inevitable economic downturns. Having systems that have been “tweaked” and refined for success – and documented and replicable (by your successor management team) – enhances the value of the business and helps ensure that any successor will be able to continue and grow the business. Documented systems that address product or service delivery, product quality and reliability, pricing and cost management, business development and customer relations increase the inherent value of the business and allow the buyer to increase the company’s operational performance and profitability.
Value Driver #3
Next, make sure that the customer base is well diversified and that the business does not generate more than 15% of its revenue from any one specific source. As contractors, most business comes from a limited number of sources; however, it’s important to determine if new products and services – or modified versions of the current offerings – can be “upsold” into the current customer base. How can the existing offerings be marketed to new customers or the existing customer base’s contractors and suppliers?
Value Driver #4
In addition, it’s critical that the business utilizes established financial metrics, such as audited financial statements from reputable third parties, and has properly safeguarded all of its proprietary trade secrets, IP and customer and supplier relationships. Being able to validate the transferable value through prior year net earnings and ensuring that customers will continue to buy from the business after the owner’s departure is mission critical to transferring the business and maximizing its financial return.
Selecting the right transition strategy
Once a constant level of transferrable value has been maintained, it’s time to determine which transition strategy is right for the owner. Generally, owners look to sell and transition their businesses to larger or comparable customers or competitors (strategic buyers) or to transfer their ownership to a co-owner; key employee or key employee group; or one or more business-active children.
If the owner doesn’t have the luxury of transferring the business to someone internal, or if the goal is to maximize the payout at the time of sale, then creating an exit strategy for a strategic sale will make the most sense. However, to attract the ideal buyer and maximize the purchase price, the owner will need to be able to prove that transferrable value has been created by implementing the previously mentioned value drivers. Buyers must be assured that the owner’s absence from the business will have no bearing on its future cash flow and growth. The pre-sale and acquisition process will consist of multiple ups and downs as the parties go through due diligence and the negotiation process. Ultimately, the goal is to minimize the buyer’s future risk by providing a business that is self-sustainable and replicable – and that can create reoccurring revenue after the owner’s departure.
For those who are fortunate enough to have co-owners, key employees or business-active children who are motivated to continue growing the business and provide the owner a platform for retirement, then there are numerous internal transition strategies.
Generally, the Shareholder or Operating Agreement will dictate the buy-out terms and valuation metrics in the event a co-owner elects to buy out the other owner when the time comes. The challenge is to periodically update those terms and conditions so that they reflect the specific transition goals and objectives. Unfortunately, most owners don’t continuously amend these terms as their needs change or after they decide on a course of action. Annual reviews and revisions are a must.
As mentioned, developing a key employee successor team serves multiple purposes. Primarily, it provides a ready-made buyer. If done properly, transitioning the ownership to key employees can prove to be best of all scenarios. It allows owners to transfer their businesses when they want to whom they want and under what conditions they require – and for the targeted amount of post-tax dollars that are needed to sustain the owner’s retirement lifestyle. There are many steps in this process to ensure the development and long-term motivation of key employee successors; however, it’s my professional opinion that this strategy generally yields the best results for most owners.
Finally, many contractors with family businesses look to “gift” or “sell” their ownership to their business-active children. Although this endeavor helps ensure the family’s legacy, it comes with many pitfalls and risks, which need to be accounted for and addressed in the planning phase. These include everything from favoritism and low employee moral to outright mutiny. However, if owners have done a good job of creating standardized operating systems (value driver #2) – including hiring requirements and employee performance standards – it’s possible to bring in, develop and ultimately promote business-active children into a leadership and successor role. As with key employees, there are various tools and techniques that need to be employed to ensure their development and ongoing support of the non-family employees.
Putting it all together
Regardless of revenue, number of employees or overall size, a successful business transition starts with an understanding of the universal objectives: When does the owner want to leave the business? How much money does the owner need to get out of the business? To whom does the owner want to leave the business? By answering these key questions, a transition strategy can be customized to allow an owner to build transferable value in a business and select the transition strategy that makes the most sense for each situation. By putting it all together in a comprehensive plan, an owner will be able to leave the business on his or her terms.
For more information regarding the contents of this article, please contact John T. Carter at [email protected].