What’s Your Exit Strategy?
The wisdom of Peter Engel, who passed on July 2010.
Unless you take the time to consider how you will leave your business, you may not be able to leave it. If you do find a way out, you may take a drastic haircut on its value. At worst, you may find yourself inextricably handcuffed to your business. You need an exit strategy.
There are seven main types of exit strategy from which you can choose, and of course there are many variations and combinations of them. Each involves a very different set of substrategies, some of which will be discussed in this chapter, others will follow in the subsequent chapters.
Here are the seven basic strategies:
A. Selling to a strategic buyer
B. Selling to a financial buyer
C. Going public
D. Selling to your heirs or employees
E. Liquidating your assets (that is, milking your business)
F. Enforced liquidation
G. Managing for life
By being aware of each strategy and its benefits and complications, entrepreneurs should be able to achieve the maximum wealth their business can possibly generate. Let me therefore describe each exit in more detail.
1. Selling to a Strategic Buyer
By strategic buyer I mean an individual or, more usually, a company that makes the acquisition in order to augment their own business. Thus, a strategic buyer benefits both from the innate value of the business being bought (as does any buyer) and from the specific synergies that result from the acquisition. Merely the ability to invest money or to run the acquired company efficiently does not qualify someone as a strategic buyer. Rather, such an acquirer would be designated a financial buyer.
The strategic buyer may be an actual or potential supplier to the business being acquired. In this case the acquisition would either solidify or increase the buyer’s sales to the acquired company to the strategic buyer may be a natural purchaser of the acquired firm’s goods or services (an automobile company buying an auto parts manufacturer, for example).
To sell to a strategic buyer at the maximum price, the seller must structure the business so that it fits in neatly with the buyer’s needs. If the fit between the firm’s goals and organizations is poor, the potential buyer- upon completing the “due diligence’ investigation that precedes any acquisitions-will be left disappointed and unwilling to close the deal, or at least close it at full price.
2. Selling to a Financial Buyer
Selling to a financial buyer requires a very different configuration for the selling company. For financial buyers, there are few synergies between themselves and the seller. Therefore, the company being sold has to stand on its own. For example, a seller may be well advised not to create sophisticated administrative infrastructure if it expects to sell itself to a large company that already has one. But it must develop such a structure if it plans to sell itself to a financial buyer. That is especially important since the financial buyer is likely to be making the acquisition with a view to rapidly expand the company being acquired. Thus, to maximize its value, the seller’s infrastructure should be strong and resilient enough to withstand the wrenching effect of rapid growth.
Financial buyers have many reasons for purchasing companies. But no matter what its field of expertise, if your company is profitable and can stand on its own, financial buyers will notice. Then they will acquire your firm, often for a premium price, if they can see a way to use your profits or cash flow more effectively than you can.
3. Going Public
Technically, going public (making an Initial Public Offering or IPO) is not an exit strategy, at least not an immediate one. That is because, in all but the rarest cases, the underwriters for the IPO will not permit the owners to sell their stock and leave the business right away. On the contrary, they are very anxious to make sure the owners stay in place as long as possible. No underwriter is going to let the owners become so rich as a result of the IPO that they can simply walk away, leaving a management void.
Nevertheless, an IPO is a legitimate first step to the exit. Once the company has been public for a few years, a secondary offering can frequently be made, and this time the original owners can sell at least a large part of their shares.
There are many structural differences between a company that intends to go public and then eventually sell out, and one that is to be sold privately. These differences range from entirely different accounting practices to equally different employment compensation philosophies. For example, to go public, a company must usually have three years of audited financials, whereas no audits are requires for a company that is to be sold privately.
When the company plans an IPO, compensation packages based on stock options can have huge benefits. However, they have relatively little value- and often impose a dangerous cash drain- if a company is to remain private. There is no doubt, then, that a company’s intent to go public will influence almost every one of its other business practices and strategies.
In order to successfully go public, you need three things:
- Solidity. This is what I call the “bricks and mortar” of a company. The bottom line is undisputable.
- Strong, proven management. Management should be competent and reliable.
- A dream. A company and its entrepreneur need to dream- and more important, they need to inspire dreams.
4. Selling to your Heirs or Employees
This type of sale is quite different from the other forms of sale for two reasons: the buyers are insiders who are intimately familiar with the business and understand its real value, and generally the buyers have neither the funds to make the acquisition nor the credentials to raise funds. Consequently, the sellers must structure their compensation as a payout of the profits generated by the business itself. This payment may have to continue over some considerable time to watch the arm’s length value of the company (that is, what it is really worth).
Of course, when selling to their heirs, the sellers may be willing to settle for a far lower price than they would accept from outsiders, in effect giving the heirs some of their inheritance in advance. Nevertheless, if the sellers expect to be paid even a reasonable portion of the company’s real value, they must structure the company before selling it so that they can be sure the acquirers are truly competent to run the business. For example, sellers who wish to sell to their heirs may be well advised to establish a wide-ranging training program for their successors, and to do this well in advance of the actual sale. Above all, this exit will require the sellers to delegate significant executive power to the future buyers long before the contemplated sale is consummated. Simply put, if Dad calls the shots until the kids are in their fifties, never letting them make a decision of any importance, he can hardly expect them to become effective, independent entrepreneurs when he finally bows out in his eighties.
5. Liquidating your Assets
A business can be sold off a bit at a time, thus milking it while it is still a viable company. This strategy is often used when it is apparent that selling the business as a whole is not feasible. Instead, each part of the business, its tangible assets, and also its goodwill, is sold separately. Sometimes the sum of the parts adds up to a lot more than the whole.
There are many ways to liquidate your assets and as many advantages to this strategy, but it is one of the exit strategies that is often misunderstood and misused. While a business is in its wind-down, milking stage, every one of its strategies obviously needs to be directed at maximizing the cost of milking them. Ideally, the milking strategy should be started long before the milking itself commences. It is never too early to develop the best strategies in the context of your planned exit.
6. Enforced Liquidation
Businesses which had considerable innate value may simply become nonviable. They may start generating losses that, by the nurture of the business, cannot b reversed. They may descend into Chapter 11 bankruptcy. Their sales may dry up to such an extent that not even such a bankruptcy seems worthwhile to the creditors. They may feel that full liquidation in a Chapter 7 bankruptcy is the only alternative.
In any of these cases, this exit of salvaging as much as possible from the ruins. Obviously, this strategic approach is the exception to the general rule that exists should be planned inception. Almost no one would plan for failure at the start of a new venture. Nevertheless, since eventual failure can often be seen well in advance of the failure itself, advance planning for the close-down is both feasible and necessary.
Careful readers will have notice that, in the preceding paragraph, I said that almost no one plans for failure at the time on inceptions. However, there is a class of entrepreneurs who do plan at their venture’s inception for “very possible” (although, not certain) failure. These are acquirers who finance their acquisitions through “junk bonds” (or similar high-risk borrowings). They realize that the burden of huge borrowings at exorbitant interest rates may well cause the acquired business to fail. However, they do not much care as long as the acquired business remains healthy except for its debt burden. That is because, if they cannot keep up with that burden, they intend to use Chapter 11 bankruptcy to keep the business but reduce the debt. This is a “heads I win, tails you lose” approach to acquisition. It works equally well if the acquired company succeeds well enough to pay off its debts or if it fails and the bankruptcy court pays off a good portion of the debt. (I do not condone the lamentable ethics of this approach, and I am frankly appalled that today bankruptcy is seen more and more as a business technique rather than as a last resort and a cause for shame. However, my aim is not to pass moral judgment, but merely to make readers aware of their options, and this is one of them.)
7. Managing for Life
The final exit strategy to be discussed is to maintain management of the business for life. While this is an exit only because life inevitably ends, it is nevertheless a frequent de facto exit strategy chosen- or at least followed- by entrepreneurs/owners. Moreover, this approach is a perfectly good one if it is chosen as an act of commission. It is highly undesirable only if it just happens. In that case, many aspects of the business are on hold during the owner’s lifetime, while employees wonder and worry about what will happen when the owner dies. Then, upon the owner’s death, the heirs face a raft of problems ranging from how to deal with probate to who is to run the business to how the inheritance taxes are to be handled.
Managing for life should be viewed as a planned strategy just as much as selling to a strategic buyer or going public. By knowing what this strategy is, owners and employees will know where they stand and will operate more confidently and efficiently.
Of course, in business- as in most things- there is an exception to every rule. Just occasionally, owners purposely leave manage-for-life planning open ended.
Managing for life can be the most misleading of the exit strategies. While most entrepreneurs would like to think that they would want to run their businesses for the rest of their lives, few stop to consider what that really means. Entrepreneurs need to know the difference between the life led by the business and the life they lead themselves.