Congratulations. Your hard work and entrepreneurial instincts have paid off in the form of a fast-growing, profitable business that’s worth millions of dollars, or could be some day. And you’re only 40. Or 30. Or, like a growing contingent of baby-faced billionaires in Silicon Valley these days like Facebook’s Mark Zuckerberg or Snapchat founder Evan Spiegel, still in your 20s.
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It doesn’t matter. When the time for the big cashout comes, you’ll wish you’d started planning for it long before. Imagine this scenario, inconceivable for a 23-year-old like Spiegel but hardly out of the realm of possibility: You’re 54 and in the final stages of an extremely expensive divorce, possibly triggered by the 2-year-old you fathered with your former employee, who is now suing you for sexual discrimination. And you just got diagnosed with a debilitating disease that will make working 60-hour weeks impossible.
Suddenly you need to sell the business you spent most of your adult life building. But when you start shopping it around, the initial offers are insulting. The buyers are fixated on silly things like reported earnings, when anybody knows a private business can be a cornucopia of valuable personal benefits from vacation trips on the corporate jet to a box at the local NASCAR track where you can watch your company-sponsored car race. Not to mention the value you built in the corporate office building you own and lease back to the company under at top-of-the-market rates!
These are all common symptoms of an entrepreneurial business that’s a delight to own but a perfect terror to sell, especially in an unexpected crisis.
“The first thing is, you have to be ready for it,” said Phil Colaco, a managing director with Deloitte Corporate Finance who advises midmarket firms on sales as well as other strategies owners can use to cash out of their businesses. “The biggest challenge we face when selling privately owned businesses is lack of preparation.”
That company-backed NASCAR team? It may pass muster with the IRS as a deductible business expense, but General Electric won’t be interested in it – and the bean-counters in Fairfield will want to see detailed financial reports so they can back out the earnings it consumes. The same thing with charitable giving, corporate real estate, and the rich benefits you dispense to your employees to buy their loyalty or just because you’re a nice guy.
Colaco recalls one company owner who every year spent $100,000 to fly all the employees to Las Vegas for a Christmas party.
“The owner was dogmatic about the fact that any buyer had to embrace the concept of this party,” Colaco said, until Deloitte advisors explained the real cost given the expected selling price of 9-10 times earnings before interest, depreciation and taxes. “We told the owner you can have the party, or I can get for you $900,000 to $1 million in extra consideration.” The party clause was dropped.
Most successful entrepreneurs are fixated on cash balances and reducing taxable income, not how their earnings may look according to generally accepted accounting principles. Outright fraud is rare in such businesses because the owners keep such a close eye on cash, but it can be expensive and time-consuming to come up with accounting statements that are convincing to outside eyes.
“It can be harder to reconcile back to historic EBITDA,” said Kevin Flanigan, national managing director of Deloitte Corporate Finance, which expanded last year by purchasing McColl Partners, an advisory firm founded by former Bank of America Chairman Hugh McColl. “The buyer has to believe the earnings are actually there.”
Real estate is another common problem. It’s a great way for the owner to build up tax-deferred wealth, but “in most cases private equity buyers are not interested in real estate,” Flanigan said. That means the owner must contemplate the value of keeping the real estate herself, as well as the possibility she’ll lose her only tenant when the PE boys move the business to Schenectady.
Executive succession is yet another thing hard-driving entrepreneurs tend to neglect. Most are focused on sales growth, not who will run the business after they’re gone – by choice or by fate.
“If you’re 40 and want to go to the beach,” Colaco said, a private-equity buyer might respond: “`I’m very happy to fund your vacation on the beach, but we need somebody to run this company.”
“If you haven’t identified that somebody, you’ve got a problem,” he said.
Buyers also tend to be suspicious if the entire business plan is locked inside the head of the owner-entrepreneur.
“The buyer is thinking, `What aren’t they telling me?’, and he’ll haircut the price,” Flanigan said.
Once the negotiations start, owners have to determine how they want to cash out. The main choices are:
- Cash. As Hugh McColl once said, “cash has no enemies.” The upside is the seller walks away, without any continuing worries about the performance of the business. The downside is taxes, which now run 20% on capital gains for high-earning households.
- Stock. The seller can avoid taxes by accepting 80% or more in stock, which qualifies the transaction as a merger. The upside is less money flowing to Washington. The downside is sellers may still have a large proportion of their wealth tied up in a business not unlike the one they were trying to cash out of.
- Debt recapitalization: Instead of selling, entrepreneurs can borrow against the business and pay themselves a big dividend. Banks are more willing to lend, Flanigan says: “It’s not 2007, but getting close.” Upside: You get the cash. Downside: You still own the company and have to run it.
- Private equity. “In the old days, private equity was never competitive with strategic buyers” like companies looking to add a new division to their business, Colaco said. Now “they’re bidding on a heads-up basis and frequently paying more than corporations,” he said. PE buyers frequently want the owner to stay on, and keep a 5%-40% interest in the business.
- Earn-outs. Many buyers prefer to pay over time and based on financial performance, which can help save taxes for the seller. But the new owner can also change management and strategy, exposing the seller to risk he wouldn’t face if he took cash. Flanigan advises clients to seek a price that is “a defensible deal at closing,” but with the potential for more money if an expected new product or strategy proves profitable.
- Going public. Having publicly traded stock “used to be an attractive asset, something to talk about at the country club,” Flanigan said. But since Sarbanes-Oxley, the costs of being a public company are prohibitive for most mid-market firms and the other options make more sense.