Part 2 of a 9 part series we'll be publishing this month. Topic today is centered on "Defining Options."
Defining Potential Options and Exit Strategies
When considering the sale of a business, there are potentially a wide variety of transaction options. These options must be understood and evaluate by the CEO, owner, and/or board. Look to your M&A advisor to introduce you to the range of transaction options that make sense for your business.
Three important initial questions you should ask yourself before selling your company are:
ɚ whether to sell to a strategic buyer or a financial buyer,
ɚ whether or not you would want to stay with the company once it’s under new ownership, and
ɚ whether right now is the right time to sell your business.
5 Differences Between Strategic and Financial Buyers
Understanding the key differences between strategic and financial buyers can help you understand their decision-making processes as you approach the sale process.
Strategic buyers are operating companies that provide products or services and are often competitors, suppliers, or customers of your firm. They can also be unrelated to your company but looking to grow in your market to diversify their revenue sources. Their goal is to identify companies whose products or services can synergistically integrate with their existing P/L to create incremental long-term shareholder value.
Financial buyers include private equity firms (also known as “financial sponsors”), venture capital firms, hedge funds, family investment offices, and ultra high net worth individuals (UHNWs). These firms and executives are in the business of making investments in companies and realizing a return on their investments. Their goal is to identify private companies with attractive future growth opportunities and durable competitive advantages, invest capital, and realize a return on their investment with a sale or an IPO.
Because these buyers have fundamentally different goals, the way they approach your business in a M&A sale process can differ in many material ways. Here are five key differences.
1. EVALUATION OF YOUR BUSINESS
Strategic buyers evaluate acquisitions largely in the context of how the business will “tie in” with their existing company and business units. For example, as part of their analysis, strategic acquirers will ask questions like:
ɚ Are the products sold to their customers?
ɚ Does your company serve a new customer segment for them?
ɚ Are there manufacturing economies of scale we can realize?
ɚ Is there intellectual property or trade secrets that you’ve developed that they want to own or prevent a competitor from owning?
Conversely, financial buyers won’t be integrating your business into a larger company, so they generally evaluate an opportunity as a stand-alone entity. In addition, they often buy businesses partially with debt, which causes them to scrutinize the business’ capacity to generate cash flow to service a debt load. Financial buyers are also focused on understanding how to quickly increase the long-term value of the company to ensure an acceptable return on their investment.
While both buyer groups will carefully evaluate your business, strategic buyers focus heavily on synergies and integration capabilities whereas financial buyers look at standalone cash-generating capability and the capacity for earnings growth.
One note of caution is that all buyers cannot be neatly categorized. Sometimes strategics are just looking to boost their earnings and end up acting like financials. Other times, financials already own a company in your space and are looking to make strategic add-ons, so they’ll evaluate your business more like a strategic. By understanding the motivations of the buyer, you can understand how they’re determining your business value.
2. FAMILIARITY WITH YOUR INDUSTRY
Strategic buyers usually are more up to speed on your industry’s competitive landscape and current trends. As such, they will spend less time deciding on the attractiveness of the overall industry and more time on how your business fits in with their corporate strategy. Conversely, financial buyers are typically going to spend a lot of time building a comprehensive macro view of the industry and a micro view of your company within the industry. It is not uncommon for financial buyers to hire outside consulting firms to assist in this analysis. With this analysis, financial buyers might ultimately determine they do not want invest in any company in a given industry. Presumably, this risk is not present with a strategic buyer if they are already operating in the industry.
As the seller, the risk of having a sale process fail due to “industry attractiveness” factors is reduced by ensuring that you are soliciting strategic buyers.
3. STRENGTH OF BACK-OFFICE INFRASTRUCTURE
Strategic buyers are going to focus less on the strength of the target company’s existing “back-office” infrastructure (IT, HR, payables, legal, etc) as these functions will often be eliminated during the post-transaction integration phase. Since financial buyers will need this back-end infrastructure to endure, they will scrutinize it during the due diligence process and often seek to strengthen the infrastructure post-acquisition.
As such, you’ll likely want to de-emphasize the importance and/or value of your back-office infrastructure in discussions with a strategic, whereas it’s important to be prepared for thorough evaluation of these functions when having discussions with a financial buyer.
4. INVESTMENT HORIZON
Strategic buyers intend to own an acquired business indefinitely, often fully integrating the company into their existing business. Financial buyers typically have an investment time horizon of four to seven years. When they acquire and subsequently exit the business, especially in the context of the overall business cycle, will have an important impact on the return on their invested capital.
For example, if your business is purchased at the peak of a business cycle for 8X EBITDA and the buyer can only sell it for 6X EBITDA 5 years later, it’s tough to make an attractive return. As such, financial buyers are going to be more sensitive to business cycle risk than strategic buyers, and they will be thinking about various exit strategies for your company before making the final decision to buy your company.
5. TRANSACTION EFFICIENCY
Financial buyers are in the business of making acquisitions. It it one of their core competencies to execute deals in a timely fashion. Strategic buyers may not have a dedicated M&A team, may be encumbered by slow-moving boards of directors, bureaucratic committees, territorial division managers, necessity to check acquisition against internal projects, etc.
From our experience, combine these factors and the process with strategic buyers can often take longer than with financial buyers. No matter what, be prepared for a 6-12 month process before you decide to sell.
Should You Stay or Should You Go?
The second important question to consider is whether you want to stay on in some capacity with your company post-sale. This will help determine what buyers you look for and how you evaluate them.
Every CEO should think about what they’re trying to accomplish with a sale, says Matt Slonaker, managing director at DelMorgan & Co., “Where do they want to be in five years? What role do they want to have post transaction? Are you looking to pull the ripcord and leave now? Or, are you looking for a partner to realize further financial or operational goals?”
The answers to these questions, says Price, have “a big bearing on how you position the company to the marketplace.”
Often, CEOs will still be weighing their options when they first meet with an advisor. “It’s incumbent upon us to help them understand the consequences of both options,” says Rob Delgado, senior managing director at DelMorgan & Co.. Private equity firms will typically require a management team to stay on board; if the management team wants to leave, then it’s time to focus on strategic buyers. “A strategic buyer will likely tolerate a weaker or more uncertain management team, because they’ll have the ability to insert their own people.”
Is Now the Right Time to Sell Your Business?
“It’s always a great time to sell!”
At some point in time, every business owner or operator will hear this phrase from investment bankers, M&A advisors, and business brokers. In other cases, business owners may find themselves independently contemplating selling their business and cashing out.
The reasons business owners start thinking about selling their companies are as varied as the companies themselves. Regardless of the instigating factor, owners should take a step back and conduct a holistic assessment of whether or not it truly is the right time to sell.
Changes in ownership are inevitable throughout a business’s lifecycle. When planned for and managed well, the transition can reinvigorate and renew a company’s mission, culture, values, and productivity. When mismanaged, however, a change in ownership can destabilize financial performance, erode competitive market advantage, shake employee and investor confidence, and damage company culture.
Using a mix of best practices focused on leadership development, practical preparation, and rigorous assessment of the underlying fundamentals of a business — both internal and external — and its current management improves the chances that an ownership transition will create value, rather than diminishing it.
There is a distinct contrast between a carefully planned transition and one made amid corporate distress. A company’s readiness for and approach to exit planning is most noticeably put to the test in times of crisis and abrupt industry changes. Whether a business is being sold at the end of a long-planned transfer or quickly being sold during a troubled time, CEOs can enhance the process by concentrating on preparation and assessment.
EVALUATE YOUR COMPANY’S FUNDAMENTALS
Closely examining your company’s business fundamentals in the years and months leading up to sale will help you more easily determine when is the right time to exit.
Leadership: Do you have the right people in the right positions to lead your company to the next phase of growth under the new owners? Prospective buyers will assess the executive leadership in the same way they would the selection of a new leader for any company. Before putting your company on the market, ask yourself whether your company’s leadership is strong enough to withstand the scrutiny.
Value protection: Now more than ever, businesses in every industry need to find innovative solutions to challenges brought about by disruption in the forms of new technologies, evolving business models, and ever-increasing customer expectations. In the post-2007, low-growth world characterized by frenetic change, potential buyers consider innovation a necessity.
Innovation: Before you sell, work to foster a culture of innovation. At the end of the day, successful innovation is not the result of luck or lone genius — rather it is the result of a disciplined, continuous improvement process with an unrelenting focus on creating the highest customer and shareholder value. Carve out time outside the day-to-day demands of deadlines and budgets to focus on strategy and exit planning.
THE THREE DETERMINING FACTORS
At the highest level there are three critical factors that inform whether or not it is the right time to sell.
1. Ownership has a highly compelling reason to exit the business. In some cases, the current ownership may have personal reasons to exit such as irreconcilable differences between the co-owners, lack of an heir, or health problems.
Other times, owners simply need to pull liquidity out of a business to invest in an emerging opportunity. Or ownership may decide that the risk associated with that business is too great. Investment criteria can also play a role if the business isn’t performing in line with the owner’s desired rate of return.
2. Ownership is fairly confident their strategic goals will be met through a sale. This may depend on current industry multiples or other market factors outside of the owner’s control. But in some cases, ownership and the business’s executives can play an instrumental role in increasing the probability of success, by a) valuing their company at or near a realistic number and b) employing a diligent and thorough process in marketing the company.
This is possibly the most important factor when deciding if it is the “right” time to sell, and is related to several external factors:
ɚ Overall performance of the global, national, regional, and local economy
ɚ Idiosyncratic risks/outlook associated with that industry
ɚ Individual company performance relative to overall market performance
ɚ individual company performance relative to its competitors
ɚ Socio-political and regulatory environment
3. Ownership is mentally prepared to divest. Are you ready to exit the business you’ve worked so hard to build? Ambivalence on this front may negatively affect the exit planning process. To prepare yourself for divestiture, think about what you will spend your time doing after you’ve exited the business, and be realistic. If you’re used to working 12-hour days, and find satisfaction in your work, you may not enjoy constant relaxation as much as you think. You might plan to start a new venture, or dive headfirst into a passion that was formerly a hobby. Perhaps you’ll spend your time traveling. Whatever it may be, crafting a plan will help make exiting your business easier.
In Part 3, we'll share thoughts and best practices on determining your valuation ranges.
Please see our intro brief on M. Allen & DelMorgan & Co.