Download Case Study #2 – Software Co.

Exit Planning for Privately Held
Businesses – Tradition or
Monetary Value?
May 12, 2006
2006 Estate & Business Planning Program
By Bill Eastwood
Doering, van den Heever & Eastwood Ltd
Offices in Fort Collins and Greeley, Colorado
Tel (970) 346-3950
Outline of Exit Planning
Alternatives
1.
2.
3.
4.
5.
6.
7.
8.
Owner’s Alternatives
Outside World
Case Studies
What is Value?
Analysis of Alternatives
Overview of the Current M&A Market
Preparing a Business for Sale
Marketing the Business
2
The Owner’s Alternatives
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Family succession
Sell the business to management team
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Leveraged buyout
ESOP
Merge the business with a competitor and
retain equity
Sell to a third party

Strategic buyer – in the business – regional bank
buys a community bank
3
The Owner’s Alternatives

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Sell to a financial buyer – private equity
(leveraged buyout), unparalleled funds available
Sale of less than 100% - recapitalization
Initial public offering for larger businesses –
Cabela’s
4
The Outside World
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Global economy
“Walmartization”
Scarcity of oil and basic resources
Growth of developing countries
General economic prosperity
U.S. service based economy
Sustained real estate inflation
5
The Outside World

Private equity and hedge funds with $100’s of
billions to leverage and invest in middle
market businesses
6
Making Correct Exit Decisions

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When is the correct time to develop an exit
plan?
Which of the exit alternatives are feasible for
the business?
Do I need an advisor team?
What is my business worth?
7
Making Correct Exit Decisions

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Does continued family ownership make
sense?
What value can I obtain by selling to
management?
What type of third party buyers would be
interested in my business?
8
Case Study #1 – Cattle Rancher
Whose Land Became Valuable


Note: All case studies are fictitious. In each
case, the owners are your clients. They have
asked your advice.
Joe Helerick sat back in his chair on his
20,000 acre ranch in Sand Hill country,
Nebraska reflecting on an offer to buy his
ranch.
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Case Study #1 – Cattle
Rancher

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He was the 4th generation family of a family who had
owned and run a successful cow/calf operation.
There had been a number of difficult times but he
now had 400 mother cows and had been able to
make a good living.
The ranch had paid to educate his two children,
Jack, age 34, a lawyer in Houston, and Jessica, a
dentist in Lincoln, NE.
10
Case Study #1– Cattle Rancher


Joe’s wife, Sandra, was tired of looking after
the cattle, particularly during cold winter
stretches like the one they were presently
experiencing.
The Helericks did have a condominium in
Lincoln and had a time share in Hawaii to
enable them to get away.
11
Case Study #1– Cattle Rancher


Running through the ranch was a “gold
medal” fishing stream where the Helericks
had been able to supplement their income
through fishing leases that now amounted to
$50,000+ per year.
The offer for the ranch was $21 million by a
group of West coast real estate developers
who wanted to build a golf course.
12
Case Study #1 – Cattle
Rancher

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Joe had had many offers before, but never
one this tempting.
Although in good health at age 63, Joe knew
that sometime in the future he would have to
decide what to do with the ranch.
Both Jessica and Jack wanted him to keep
the ranch, but had no interest in returning or
assisting in the maintenance.
13
Case Study #2 – The
Impressive Software Co.

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Jack Calvert of Lincoln, Nebraska, had a
critical decision to make. At age 70, he had to
decide what to do with his computer software
company that made specialized software for
the oil and gas industry.
The company had been very successful and
Chuck MacIntire, age 49, had managed the
business for a number of years without any
real day-to-day management assistance from
Jack.
14
Case Study #2 – Software Co.

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Jack had been instrumental in helping make
several add-on acquisitions.
Sales of $11 million generated $2.7 million of
EBITDA for 2005.
Jack had received numerous offers over the
years to buy the business.
15
Case Study #2 – Software Co.

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He had received numerous calls from investment
bankers telling him of the advantages of selling to
the employees with a private equity group owning a
large part of the business and the management
owning a minority stake.
Other investment bankers had wanted to have an
auction to sell the property to the absolutely the
highest bidder without any consideration for the 40
employees, many of whom had worked at the
business for many years.
16
Case Study #2 – Software Co.

Jack now spent 3-4 months of the year
hunting and fishing with a little golf in
between his home in Hawaii, his condo in
Cabo San Lucas, and an elegant home in
Lincoln, Nebraska.
17
Case Study #2 – Software Co.
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Neither of his children, Jill nor Bill, were
interested in the software business and were
well taken care of from his estate through
other means.
Jack was an avid University of Nebraska
football fan and had attended every game for
the last 7 years (even in 2004).
18
Case Study #2 – Software Co.

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Jack talked to an investment banker friend of
his regarding valuation of the company.
The banker placed a preliminary valuation of
$17-22 million on the business that had been
growing 8-10% annually.
19
Case Study #2 – Software Co.

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Jack sat down with the key management
people at the company.
He asked them if they were interested in
buying the business. They said that they
were very interested in buying the business.
He also broached the idea of a private equity
firm taking most of the risk and management
owning a minority position.
20
Case Study #2 – Software Co.

Jack also discussed the opportunity to sell to
a large software company where the best
programmers would have opportunities
outside his company.
21
Case Study #3 – The Wishful 3rd
Generation Community Grocery Store
Owner


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Rick Hayworth, age 67, was a third
generation independent grocery store owner
in Crete, Nebraska.
He had operated the business for 25 years
and was in good health.
Two years ago he had turned the day-to-day
operations of the business over to his son
George.
22
Case Study #3 – Grocery Store
Owner

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George, age 44, had two ambitious sons who
also worked in the business.
They had recently moved their store to a new
25,000 sq. ft. modern grocery store with deli,
bakery, pharmacy, “all the things that bigger
stores had.”
His store was supplied by a national food
cooperative to keep the business competitive.
23
Case Study #3 – Grocery Store
Owner
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Rick was evaluating an offer he had recently
received from Safeway, a national grocery
chain.
Because Crete was a fast growing
community and the wishful grocery store met
its specifications, Safeway wanted to have a
good footprint in the location (population now
7,000) without having to compete head to
head with the community grocery store.
24
Case Study #3 – Grocery Store
Owner

Hayworth was also contemplating an offer to
buy two other independent grocery stores in
adjoining towns, that were being sold by
another independent grocer who was retiring,
for George’s sons to manage.
25
Case Study #4 – The CNC
Machine Company Co.
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Dave MacIntosh and his two brothers, Tom
and Mike, were contemplating what to do with
their business.
The business had grown to almost $20
million in annual sales with profits exceeding
$5 million per year.
26
Case Study #4 – CNC Co.

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They made medical components, triggers for
air bags, computer disc drives, defense
contractor parts and other specialty
components.
The Computer Numeric Control Machines
(“CNC”) (patterned on Swiss watch
technology) were one of the fastest growing
manufacturing machines in the world.
27
Case Study #4 – CNC Co.
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Because the machine could make up to 50
different cuts on one component (none larger
than your hand).
Once the machine was configured, it was
reliable and could run lights out 24/7.
28
Case Study #4 – CNC Co.


Dave, at age 44, knew that the market was
excellent for his business.
An investment banking firm had advised them
that they should explore exiting the business
due to increased threat of foreign
competition.
29
Case Study #4 – CNC Co.


Their mother, age 66, owned one-fourth of
the company.
She had kept the company and the family
together during very difficult times when their
father had died 15 years ago at the age of 49.
30
Case Study #5 – The Case of the
Successful Cabinet Maker Who Waited Too
Long


Joe Seamster had been very successful
making customized cabinets for regional
home and commercial builders.
His operation was efficient enough to sell
quantities to the large box stores (Lowes,
Home Depot) to keep his production lines
moving smoothly during the slow periods
even though his margins were much less.
31
Case Study #5 – Cabinet Maker

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Joe, at age 65, had completed a major plant
expansion to take care of the booming real
estate market in Lincoln in 2005.
The company had spent $3.5 million ($2.5
million financed by an industrial revenue
bond) and had also added over another $1.0
million in equipment.
32
Case Study #5 – Cabinet Maker

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The business currently made about $2.0
million a year on sales of 18 million.
Twelve months ago, Joe, a heavy smoker,
found out that he had lung cancer. He had
fought valiantly. Recently he was informed
that he had less than 3 months to live.
33
Case Study #5 – Cabinet Maker
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Joe had an excellent general manager who
was capable of running the business.
His wife, Josephine, knew nothing about
business and was totally reliant upon all of
Joe’s decisions.
Their two children, Steve and Dick, were both
trying to find their way in life and lived in
Boulder, CO. To date they had shown no
interest in the business.
34
What is Value?
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Value is measured differently by each buyer
or owner
Not all value = $

Social, Ethical, Moral, Religious, Sentimental,
Economic and Commercial Value
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Emotion
Legacy
People factor
35
What is Value?

Going Concern Value
 Fair Market Value = $$$$
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Capitalization of Earnings
Discounted Cash Flows
Market Approach
36
Family Succession
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Often emotional attachment to business
Usually owner carries note
Not usually the best way to maximize
financial value
Usually results in ongoing risk to seller
37
Family Succession
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Hard questions
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Does the next generation have the ability and
desire (passion) to successfully manage?
Can the business compete effectively in present
environment?
Need to grow
Need to sell to a larger strategic competitor or
orderly liquidation
Need to diversify
38
ESOP (Employee Stock Ownership Plan)
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Enables employees to acquire beneficial ownership
in their Company without having to invest their own
money
Advantage of the ESOP is that employees are able
to acquire this stock without paying a current income
tax on the stock
The advantage to the Company is that the ESOP
makes pre-tax dollars available to finance Company
growth and/or to create ownership liquidity at the
time of retirement
Owner has tax advantages on sale proceeds
39
Recaps & Mergers
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Management leveraged buyout
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Feasibility and cash flow business
Partial sale or recapitalization?
 Sale of majority or minority stake
 Leverage the business
 Risk of ongoing ownership
 New partners
Merger
 Usually paid in stock of merged entity
 Liquidity event dependant on future success of merged
entity
40
Outright Sale
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Individual (small deals < $3 million)
Strategic/synergistic buyer (all sizes)
Financial buyer > $3 million or larger
41
Robust M&A Market
42
Robust M&A Market
43
2005 Value Multiples
All Manufacturing Companies by Revenue (North America)
Annual Revenue
Medium Multiple (EBITDA)
$ 50 Million - $200 Million
8.2
$20 - $50 Million
6.8
$10 - $20 Million
6.4
Under $10 Million
5.4
Source: IMAP 2005 Pricing Survey Results. IMAP members around the world advised on
220 transactions with $4.079 billion in valuations.
44
Structure of the Deal Affects
Value
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Currency
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Cash is king
Seller financing brings higher price
 Particularly on deals valued under $25 million
Stock swap — tax deferral and liquidity consideration,
negative stock market risks
Stock or asset sale
45
Value of Privately Owned
Businesses
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Factors that differentiate an 8x+ multiple business
from a 3x (an “A” business from a “C” business):
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Industry (growth vs. stagnant)
Size (Scalability)
Growth in sales (speed to acquire opportunity)
Earnings — growth, quality and consistency
Balance sheet strength
Perceived competitive advantage — brands, patents,
technology, costs
Margin as percent of sales
Strength and continuity of management
46
Value of Privately Owned
Businesses
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Exceptions to the 3 to 8 EBIT rule:
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Each buyer will have a different criteria for
valuation
Some buyers and industries use EBITDA rather
than EBIT
Examples:
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Private equity firms evaluate based on projected ROE
Food brand purchaser may project savings in costs from
adding a brand to its existing distribution system
Cable company businesses sold on a value per
subscriber
47
Who Are The Buyers?
Strategic / Synergistic Buyers
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Strategic / Synergistic Buyers
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A buyer in the same business or industry as the seller
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Consolidating industry or segment
Economies of scale
Expansion of product line or service
Acquisition of clients or technology
Often pay price based on their own ROA or ROI multiples
May pay large premium if they feel it will give them major
competitive advantage.
Often make acquisitions to prevent any other competitor from
owning company - defensive.
48
Who Are The Buyers?
Financial Buyers
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Private Equity funds raised over $1 trillion from 1997-2005
 Hundreds of billions left for investment
 April 2006 – KKR completed public offering of $5.5 billion
 Barron’s April 24 estimated Middle East 2005 investment of
$118-120 billion
Thousands of buyout funds with billions in capital can
generally borrow 1-3 times equity to buy a company
49
PE – Funds Available To Invest
98.6
1996 ‘
1997
1998
1999
2000
2001
2002
2003
2004
2005
Private Equity Appetite: Money Looking for Work
Average PE fund has approximately 53% of its committed capital invested New
fundraising activity has continued to grow in 2006
Source: : Thomson Financial & Robert W. Baird
50
Who Are The Buyers?
Financial Buyers
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Financial buyers — “private equity funds & leverage
buyout groups”
Use equity provided by institutions, pension funds,
insurance companies and other investors
Borrow money to increase the return
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WACC (weighted average cost of capital)
Leverage is cheap and tax deductible but cost is increasing
Looking for a return on Investment (ROI)
Large pools of funds to invest
51
Financial Buyers
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Not hands on managers (manage money, not
companies)
Many different types of buyout funds
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Some look to consolidate a niche industry
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Each has a profile of types of investments pursued by size
and industry
Almost all have a limited ownership time horizon (5 years
average) to sell the company
Most encourage management to own part of the
company (5% — 20%) (vested interest)
52
Financial Buyers
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Look for 25% — 35% Return on Equity
Have different minimum earning thresholds
EBITDA of $3 million - $50+ million
Most may consider even smaller “add-ons” that
complement an existing business
53
Who Are The Buyers?
Private Investors
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Local entrepreneur buying a business to own an
asset that they manage and control
Often buying a job
Looking for insulation from employer
Deal Size is usually an issue
Financing sources limited – banks, leasing
companies & seller finance
Buyer often does not understand the risks or price
Seller usually overestimates the value (emotional)
54
The Marketing Process

Prepare Business for Sale
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Dressing up prior to sales effort
Maintain management continuity
Utilize pass through entity (Sub S, LLC)
Identify and resolve litigation, intellectual property,
environmental and other contingent liabilities
Determine reliance on key customers or suppliers
Identify personnel issues
Obtain audited financial statements
55
The Marketing Process

Offering for Sale
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The team is critical – lawyer, accountant, trusted financial
adviser, and investment banker
Determine advisability of a M&A professional
If M&A professional desirable, evaluation and choice is
critical – make sure that there is a good fit with
management and owners.
Cost of M&A representation = 2% - 5% of deal value
56
The Marketing Process

Business Sales Strategy
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Prepare a Business Summary or Offering Memorandum
and Teaser
Identify potential buyers
Open negotiation process:
 With one purchaser at a time
 To a few prospects (“Selective Marketing”)
 With a controlled auction to all qualified prospects
57
The Marketing Process
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Major Legal Documentation
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Confidentiality agreement
Letter of intent
Due diligence
Definitive agreement and closing
Management must concentrate on running the
business
58
When Should A Business Be
Sold?

Objectively Analyze Business’s Sales Prospects

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When the business Is performing well
When there are good prospective buyers able to act within
a reasonable time
When the owner is committed to spending the time and
money to market the business properly
When the condition of financial records are sound
 Are the financial statements audited?
 Possibility of restatement in due diligence?
 Entity profitability is healthy
 Cash flow is strong
59
When Should A Business Be
Sold?
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When contingent liabilities are limited and estimable
 Warranty claims, environmental, employee issues, litigation
Owners start to lose the passion for continued growth and
progress.
 If you are not passionate about the business, your entity
value is probably stagnant
Management team has been groomed to run and grow the
business
60
Timing Your Transaction
“Better to sell too early than too late, but pretty nice to sell on time”
Schedule your transaction by your company’s timetable, not “the market”
24 to 36 months in advance (“Maybe”)
12 months in advance (“Probably”)
Pulling together your team (“Go”)
61
Why Deals Do Not Get Done
Source: Baird 2005 US Middle-Market Private Equity survey
62
Conclusions
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Successful businesses are marketable
Business transfer is a marathon, not a sprint
Seller must be realistic about price and timing
Having a trusted team is critical
Do not ignore running the business

If business falters, all else is lost
63
Case Study Discussion
64