Exit Planning Exchange

By Laura Kevghas

The phone rings unexpectedly one day, and on the other end is a CEO wondering if you would be willing to sit down and talk about selling your business. You may or may not discuss a purchase price. You may or may not commit to even a meeting, let alone an exchange of information. But nonetheless, that single unexpected phone call can touch off one of the most significant, emotional and time-consuming events in your life as a business owner: deciding whether to sell your company. The way you respond, both initially and in the weeks that follow, can have an impact on your company, your employees, and the value you can realize from the sale of your business.

For this article we asked experts in accounting, law and business consulting for advice on what to do when you receive this kind of phone call. Their suggestions – on everything from evaluating pricing, to managing proprietary information, to establishing a team of advisors, to performing due diligence on the buyer – can help you navigate the complexities of your unsolicited offer, and make the most of your opportunities, whether you decide to sell or not.

Why This Matters:

• Planning ahead can make the unexpected offer manageable
• Contemplating selling your business is the most significant and emotional decision you’ll ever make
• Even considering an offer can affect your company, your employees and your family

Top ten rules for evaluating unsolicited offers

Though every company – and every deal – is different, we have found that there are a number of simple principles that can simplify the process of responding to an unsolicited offer and help you make the right decisions. Here are ten things to keep in mind when someone offers to buy your business:

Rule #1: Don’t wait until the offer comes to plan your response

“Unsolicited offers can come at any time,” says Tom Sherwin, founder of the consulting firm CEO Resources,Inc. “Ideally, CEOs should have a strategic plan in place before they get an offer.” That plan doesn’t have to be complicated, he adds. CEOs simply have to know whether they plan to continue to manage the business over the next three to five years, or whether they would be open to the possibility of a sale.

Linda Swerling, founder of Level II Solutions, adds that business owners should consider their personal, as well as financial, goals. “How long were they planning to work? What was their exit strategy for the business? All these things need to be written down,” she says.

Sherwin says that he regularly meets with CEO’s who maintain that they have no interest in selling theircompanies; yet it’s often merely a question of price. “We play a game of ‘what if’ scenarios, usually over lunch,” he says. “What if someone offered you 20% more than you think your company is worth? What about 50%? You end up constructing a game plan. Say, for instance, that you would consider offers above 25% of some benchmark. At 50% you would actively pursue a deal. And at 100% above the benchmark, you schedule a closing. Then you put that game plan away until the time comes.”

Rule #2: Know what your company is worth

Of course, you can’t evaluate an offer without having a very good idea what your company is worth. Public companies learn their value every day when the market closes, but for private, closely held companies, it may be worth spending the money  required to get a good valuation at least every three to five years, Sherwin suggests.

Amy Mastrobattista, an attorney with the Boston law firm Ruberto, Israel & Weiner, says that the first stop should be your CPA, who can walk you through the most appropriate valuation techniques for your company and industry. “It’s also not a bad idea to develop a relationship with an investment banker far in advance of any planned exit,” she adds. “They can incorporate their knowledge of market conditions, recent transactions and prevailing multiples in your industry to give you a more accurate view of your company’s value.”

“To truly understand your company’s worth, though, you need accurate and timely financial information,” asserts Swerling. “Your current performance relative to last month,the year-earlier period and budget all influence the value of your company.”

The integrity of your financial data is important, not just in understanding the value of your business, but in presenting it to outsiders, comments Margery Piercey, a CPA with the accounting firm Wolf & Company. “First impressions are important when you put numbers in front of a potential buyer.  And it can have an immediate impact onvalue if your financial statements aren’t in order. You reallyneed to make sure that your numbers are presented in sucha way that you’re going to be maximizing value, by ensuring that your financial statements are in compliance with GAAP and industry-specific reporting norms, and that you’ve identified any owner-related or other expenses that won’t continue post-closing.”

Rule #3: Protect your company’s proprietar y informat ion

Very early on, potential buyers will often request extensive proprietary information about your company.  It’s important to provide information in stages – very little early in the process, and further information in pieces, only as you become comfortable that a transaction with this potential buyer is desired and likely.

However, Mastrobattista points out that “Before you share any information at all with a prospective purchaser, you need to have a good confidentiality agreement inplace. This is the case even if the potential acquirer is not a competitor. You don’t want your confidential business information to be used for any improper purpose, even if youthink it’s innocuous.”

Piercey concurs. “Usually in the early stages of getting to know your potential buyer, you are going to be disclosing a good deal of information,” she says. “It’s important that your attorney has put a strong confidentiality agreement in place to make sure you’re properly protecting trade secrets, customer lists, and other things that contribute to the value of your company. That way, if the deal doesn’t go through, you haven’t given away some of these things of value.”

Rule #4: Keep it quiet

These negotiations should, in most cases, be kept confidentialfor as long as possible. “The impact on the employees of even considering a sale of a business can be very unsettling and actually can reduce the value of the business,” says Piercey.

“Control of information is critical,” adds Mastrobattista. “Rumors about your deal can affect not just employees, but customers, vendors and lenders. If the transaction falls through, it can even have a negative impact on your company’s reputation, since people may assume there was something wrong with your business.”

Mastrobattista advises CEOs to think carefully about who within the company needs to know the details of a transaction and to limit the access to this information to a small group of top managers for as long as possible.

Rule #5: Put together a team of expert s

“Acquisitions take up a good deal of time – incremental time over what the CEO is already spending on the business,”says Piercey. “Moreover, they require experience and insight that most CEOs don’t have. As a result, it is critical that the CEO bring in people who are experienced in transactions: investment bankers, accountants, lawyers and tax advisors.”

“You’re only going to sell your business once, and it’s a steep learning curve,” cautions Sherwin. “Why would you try to do that yourself?” He advises seeking out experienced transaction professionals, people who specialize in M&A and work on multiple transactions every year. He recommend stalking to other CEOs who have sold their businesses for referrals to investment bankers in your market.

Mastrobattista adds that you can often find these people by asking your current team of advisors. Your regular accountant, for instance, canusually recommend a taxspecialist experienced in M&Atransactions to augment his or her expertise. Your general counsel may know an M&A lawyer. “The best place to find good people is from good people,” Mastrobattista says.“Talk to your trusted sources for business referrals and evaluate independently.”

Rule #6: Scrutinize deal structure and provisions carefully

Price is one key factor in a deal, but it’s not the only one.“You and your team should look closely at the structure of the transaction,” says Mastrobattista. “Is it cash? Is it notes? Is it stock? Are there hold-backs? Are there earn-outs?” There are tax implications to all of these different purchase price methods that a good tax advisor will help you evaluate. Each structure has different risk implications as well, with payment in seller notes or earn-outs increasing the risk that you won’t receive the value you expected from the transaction.

Rule #7: Think about other possible acquirers

“Just because one person is interested in buying your business doesn’t mean you have to sell it to them,” says Sherwin, adding that there may be multiple offers out there, in addition to the unsolicited one.  For CEOs who are interestedin pursuing a sale, he recommends widening the circle of potential buyers, not just approaching known competitors, but a larger circle of complementary, often larger potential buyers.

Unearthing these buyers may require an investment banker’s help, Sherwin adds, and Mastrobattista concurs that their insight can be invaluable. “You need to look at the state of your company and of the market as a whole when you think about soliciting other offers,” she says.

Deciding to widen the circle of potential buyers carries with it the risk that the buyer who gave you the unsolicited offer may not wait for you to test the market. This is when an investment banker can be particularly helpful to determine if the offer on the table is pre-emptive enough to be worth accepting to the exclusion of other potential buyers.

Mastrobattista adds that bankers can tell you more about the market’s appetite for deals like yours, but that ultimately, the transaction should be done on your timetable. “There’s nothing worse than rushing a deal through, not understanding all the implications of price and market conditions, and then getting bitten in the end.”

Rule #8: Check out the buyer carefully

CEO’s should also scrutinize their potential buyers carefully.  Sherwin says he is always astonished when a company owner agrees to a transaction without first verifying that the buyer can pay. “There are a lot of people out there who can’t close,” says Sherwin. Particularly in today’s tight credit climate, you want to know that the buyer has the financial capacity to close the transaction.

Rule #9: Plan your post-transaction role car efully

You sell your company, and what then? Every one of our experts maintains that you should think carefully about what, if any, role you play in the acquired company.

If the transaction is structured to include an earn-out, you may wish to continue to run the business through the earn-out period to ensure that the maximum incentive payment is earned.

However, Swerling suggests that CEO’s consider the implications of their shift from owners to employees, if they continue in the business. “You’ve been managing this business for years or decades. You’ve been doing everything your way, maybe with the support of some hand-picked managers. Now it’s not yours anymore, and the company you built will change,” she says.

Rule #10: Don’t be afraid to walk awa y

Given the intense and emotional nature of negotiating a sale, our final rule is perhaps the hardest to follow. If a transaction turns out not to be in the best interest of you or your company, you need to be willing to pull the plug.  Not every deal is a good one.  Sometimes even attractive transactions can turn sour over the course of negotiations, or as market conditions change. Even if you’ve spent months working on a transaction, it may still be better, at a certain point, to simply walk away.

Unsolicited doesn’t have to mean unanticipated

Unsolicited offers happen more often than you think – and they can be a welcome wake-up call to business owners caught in the day-to-day details of running a company. Yet they shouldn’t take you completely by surprise. Sound preparation for an unsolicited offer is good strategic planning.

By developing a strategy that says whether, when and for how much you would consider selling, by obtaining accurate valuations of your business on a regular basis, and by developing relationships with seasoned M&A advisors now, you can make sure that you maximize whatever opportunities come your way in the future.

Laura Kevghas is a principal at Mirus Capital Advisors, Inc. Founded in 1987, Mirus Capital Advisors is a middlemarketinvestment bank that specializes in merger advisory, capital-raising services, fairness opinions andvaluations to entrepreneurs, corporations and professional investors. By combining a proven process, industry andtransactional expertise, and personalized service, Mirus has completed hundreds of transactions for both publicand private companies. Our affiliate Mirus Securities, Inc. is a registered broker-dealer and FINRA/SIPC member.Additional information about the firm is available on our website www.merger.com.

By Joseph C. Marrow

Choosing the best exit strategy for a company is a daunting task.  The goal for business owners is to maximize the value of the enterprise for themselves, their employees and their stockholders.  Some popular exit strategies include a sale to the highest bidder or a strategic partner, a public offering in the United States or abroad, or a sale of an interest in the business to a private equity investor.  To determine the best alternative, it is necessary to weigh several factors.  Is the business best positioned for a sale (based on the industry or the scope and size of the enterprise) or do the public markets or a private equity investor present an opportunity to brand and grow the business?  Do the business owners desire to remain with the company or is the preference for a clean break?  Is it a buyers or sellers market?  Are the capital markets open to new issuances?  These are some of the questions that should be assessed when making a determination how to proceed.  The best advice is to plan ahead.  Even if you have no immediate plans to pursue an exit, you should understand the markets and think strategically to best position your business for a liquidity event down the road.

Planning for an exit event is critical for you and your business.  What steps should you be taking in the planning process?  As counsel to a variety of business at different stages, we are often asked to weigh in on strategic alternatives.  Having worked with business owners over the years in planning for and effectuating liquidity events, several common themes have emerged.

1.  FOCUS ON EXECUTION

Above all else, keep focused on the execution of your business plan.  Planning for and executing a liquidity event can be an extremely time consuming and distracting process.  Don’t let it be!  If you remain steadfast in the achievement of your business objectives, execute on your plan, dedicate yourself to attracting real customers and revenues, your exit event will take care of itself.  The primary focus of the business owner should always be on the success of the enterprise, not the consummation of the exit.

2.  BE BOUGHT, NOT SOLD

One common mistake business owners make in the pursuit of an exit strategy is to lose sight of the short-term needs of the business.  For example, a business may have some short-term capital needs to address to attract, retain and grow its customer base.  The business owner, believing an exit event is at hand, may elect to forego the short-term expense in light of an impending transaction.  A failure to address short-term cash needs, however, could have long-term repercussions.  Several factors dictate that it is better to spend the money now.  Transactions can often disappear as easily as they arise or a transaction can take significantly longer than expected.  Equally important, the long-term success of the business may be tied to the transaction.  Often times earn-outs, bonuses under employment contracts or other consideration depend on the financial performance of the seller’s business post-liquidity event.  For these reasons, sellers should continue to run their businesses in the ordinary course and meet short-term capital needs to achieve long-term objectives.  Saving a few dollars now could certainly cost the seller many dollars in the long run.

3.  SURROUND YOURSELF WITH EXCELLENT ADVISORS

Unless you have some transactional experience, a liquidity event poses many challenges to a business owner.  The nature of the transaction (M&A or IPO), the specific terms of the transaction and continuing obligations after the sale, employment issues and tax and accounting considerations present a litany of issues to consider.  It is neither necessary nor advisable to go through the process alone.  Seasoned professionals are available to guide the seller through the process.  Very early on, you should engage an experienced attorney, accountant and other advisors (such as an investment banker) to assist you.  Lean on your advisors.  It is not uncommon to hear the CEO of a company explain that he or she has achieved great success because he or she has surrounded himself or herself with smart people.  If you choose carefully, the advisors will have a great deal of experience to draw from and will be able to provide excellent guidance recommending exit alternatives, structuring the transaction, avoiding pitfalls, preparing the company for a liquidity event and completing the transaction.  Many business owners raise concerns regarding the costs involved in engaging service professionals, however, most business owners that have experienced a liquidity event will attest that the right professionals add to, rather than detract from the value of a particular transaction.  In addition, the better the advisors, the more time a business owner can devote to the matter at hand – the day-to-day operations of the business.

4.  CHOOSE CORRECT EXIT STRATEGY

There are several options when considering exit alternatives.  For many, a sale of the business is the logical choice.  Others may opt to raise money through the public markets or to sell a piece of the company to private equity investors.  Recently, the public markets, in particular, have not been an attractive option.  While many are familiar with the perceived downsides to going public (compliance costs, personal liability exposure of officers and directors and short-term financial performance pressures), there can be legitimate reasons to test the public markets (creating a national brand, providing liquidity to employees and investors or using the publicly-traded stock as currency in a roll-up strategy).  Still others have used the public offering route to attract buyers.  In addition, private equity can provide a much needed capital infusion to a company.  A business that accepts private equity investment should note that with the investment comes a fairly short-term liquidity horizon – 5 to 7 years to position the company for sale or to go public.  Once again, professional advisors can be extremely helpful in vetting the available options and guiding a business through the process.

Choosing and pursuing an exit strategy is both exciting and intimidating.  A business owner contemplating a liquidity event is faced with a myriad of issues.  Selecting the correct route to follow is not always easy.  Moreover, above all else, in pursuing a liquidity path, make sure your number one priority is the continued health and prosperity of the ongoing business.

For more information, please contact Joseph Marrow at jmarrow@mbbp.com.

By Sarah C. Richmond

The day you dreamed of has arrived: SuperCo has just offered big bucks to purchase your company. Before buying the Porsche, keep in mind that the purchase price is only one factor that determines how much money you will get out of the deal. The founder who is aware of the pitfalls will best be able to maximize her value in the sale.

I. Be Careful Along the Way.

A company that has reached the point of sale after one or more venture rounds will have negotiated preferred stock terms with its venture capitalists along the way. A founder who does not pay careful attention to the VC’s liquidation preference may be in for a rude awakening when the VC walks away from the sale with a lot more than the founder expected.

The liquidation preference is the amount the VC gets upon a liquidation, merger or sale of the company before any payments are made to common stockholders. The most typical liquidation preference (and most appealing to founders) is one where the VC receives his original investment back if it is more than he would get by sharing in the sale proceeds on a percentage basis. This way the VC gets his money out first if the company is sold in a fire sale.

A more aggressive VC may try to impose what’s called a “participating preferred” liquidation preference, which is much worse for the founders. With this stock, the VC gets his original investment back in a sale of the company (or even a multiple of his original investment), and then also shares in the remaining sale proceeds on a percentage basis. If you hit a home run, the participating preferred benefit will be lost in the rounding error. If you only hit a single or a double, it can dramatically shift the benefits of the sale from the founders to the investors. Since you can never be sure about where you will end up, try to avoid giving a participating preferred liquidation preference if you can.

II. Talk to a Tax Lawyer.

A common mistake founders make when selling their business is talking to “the tax guy” too late. There are lots of ways to structure a deal (asset sale, stock sale, merger), multiple company structures (S Corp., C corp., LLC), and various combinations of stock and cash that can be given as payment. Each structure has its own tax consequences for both the buyer and seller, and there are ways to minimize and defer the taxes if you get the structure right from the start. It’s not too early to think about these concerns when you first set up your company.

Will officers be subject to ongoing employment, consulting or non-compete agreements with the buyer? If so, it might save tax dollars to allocate some of the purchase price to these agreements. A good tax attorney can help you work through this, so talk to one before signing a letter of intent.

III. What are you Getting?

You can be paid in stock, cash or a note (which is less common). Cash is always taxable, and stock may be taxable, depending on the deal. If you are getting stock, don’t assume that you can go out and sell the stock the day after the deal closes just because it is public company stock. Why not? In order to be able to sell the stock, the stock must either be registered as of the closing, come with registration rights, or become eligible for sale under securities laws within a short period of time.

IV. When are you Getting it?

Timing of the purchase price is also key, and buyers can tinker with the timing by using an “earn-out.” This is where the seller receives part (or even all) of the purchase price after the closing, depending on the performance of the seller’s business. An earn-out is useful when the expected profitability of the acquired company is hard to assess at the time of closing. From a seller’s perspective, an earn-out has several problems: it is difficult to come up with an exact formula to measure performance, the seller is dependent on the buyer to provide the necessary resources to make the earn-out happen, and many acquisitions fail, resulting in little or no earn-out payment.

What should you do in an earn-out situation to maximize your eventual payout? Accept an earn-out only when one or more of the selling shareholders will stay on with the buyer and exercise control over development and marketing of the acquired assets. Make sure the earn-out formula directly tracks the performance of the assets acquired in the sale, rather than the seller’s overall business. Evaluate the timing of the earn-out, as well as the milestones and the likelihood of achieving them. Make sure the buyer commits to a large enough marketing and hiring budget for the entire earn-out period. Maintain as much control as possible over whether the earn-out is reached: paying attention to these details before the sale is finalized is the best way to do that.

IV. Beware of “Hidden” Liabilities.

A buyer can put mechanisms in place which can lower the value of the sale after the closing. In an asset sale context, the buyer can exclude specified liabilities of the seller, and those liabilities can reduce the purchase price post-closing when the seller is stuck with the bill. Also, many purchase agreements are drafted with such strong representations, warranties and indemnities that the selling shareholders remain exposed long after the deal is done. Review the deal documents carefully: watching your purchase price disappear after the closing can be a very painful experience.

V. Be Smart.

Evaluate your buyer. Most deals these days are paid for with at least some stock, and the selling shareholders will thus become partial owners of the acquiring company for at least some period of time. Also, many (if not all) of the seller’s employees will typically continue on with the acquiring company. Do your homework and carefully evaluate the strength of your buyer. Make sure you are joining forces with a company you believe in.

Bring a knowledgeable lawyer into the process early on. The farther along in the process you get, the less room there is for the lawyer to help.

Last but not least, don’t forget to run your business while negotiating the sale. Deals crash for all sorts of reasons, and you don’t want to be left holding less than what you started with.

Sarah C. Richmond is a partner at Gesmer Updegrove LLP, a Boston law firm focused on entrepreneurial companies and their investors.  She can be reached at sarah.richmond@ gesmer.com

By Sarah C. Richmond

Many companies do not work with their lawyer in a very efficient way, and as a result end up spending significantly more money than is necessary for services that are less than optimal. Keep the following in mind to improve your company’s legal services in terms of cost, effectiveness and responsiveness.

Keep your lawyer informed.

Most business lawyers bill by the hour and, as a result, clients try to minimize their contact with them. However, you are far better off in the long run if your lawyer is kept current as to your company’s activities. Discuss how you might set up a regular program to keep your lawyer up to date as part of your team. For example, invite your lawyer to attend your board meetings. Send your lawyer periodic emails with status updates. Meet your lawyer for breakfast or lunch a few times a year; a good lawyer should not charge you for this time and will be glad to have the opportunity to get to know you and your business “off the clock.” But, do bear in mind that a lawyer’s inventory is her time, so don’t abuse the right.

Many lawyers can provide services beyond mere legal advice. For instance, many business lawyers will have a network of contacts in accounting, banking and insurance that you can easily tap into if your lawyer knows what your business needs are. Some corporate lawyers will have ties to the venture capital and angel investor community. Keeping your lawyer informed about your company’s activities, needs and goals can open a lot of doors for you.

Be proactive rather than reactive.

Be proactive with your attorney to help you catch problems before they become too serious. Too often, lawyers find out about a legal issue the company is facing after it’s too late to nip it in the bud easily. Avoid the predicament of clients who say to their lawyer “I signed this agreement. Could you review it and let me know that it’s OK?” By this time, it’s too late and it’s usually not OK. Have your lawyer review any significant agreements before signing them. Don’t try to do your own incorporation without the help of a lawyer. And don’t issue securities without consulting with a lawyer. It will always cost more to fix something after the fact than to do it properly from the start.

Allow your lawyer to prevent fires from starting rather than just putting out the flames after the fact. Make sure you give your lawyer all the facts. You may think you are saving money by keeping the information you share with your attorney down to a bare minimum. But it may not be obvious to you which facts are relevant and which are not, and omitting a key piece of information can lead to inaccurate legal advice. Keeping your lawyer informed before taking action can help prevent you from getting sued, unknowingly giving away rights to your core technology, jeopardizing important employee and customer relationships, and compromising other important aspects of your business.

Stay organized.

Sign documents your lawyer sends you and send them back, rather than letting them pile up on your desk. Make sure to send a copy of all executed contracts, minutes and other important documents to your lawyer for her files. Most lawyers bill by the hour regardless of the task, so remember that an hour of time spent by a lawyer trying to track down a missing client document costs the same as an hour of the lawyer’s time in providing substantive legal advice. Try not to make your lawyer do your work for you.

Plan ahead for meetings and phone calls. Send your lawyer an agenda of the topics you want to cover in advance. This will enable your lawyer to do necessary background research or analysis before the meeting rather than after, making the meeting go much more smoothly and getting you answers sooner.

Give advance notice.

Plan ahead to the extent possible when you think you will need legal help down the road. Giving advance notice allows your lawyer the time to assemble the proper team, resulting in lawyers who are at the appropriate skill level (and billing rate) to perform the work required.

Set reasonable deadlines. If you don’t actually need something by tomorrow, don’t make your lawyer jump through hoops to have it done by then. Setting unreasonable deadlines can result in lawyers and staff needing to work overtime, take cabs home and eat dinners at work, all at your expense. Allowing your lawyer to plan his life in advance will result in legal services being rendered more efficiently.

Discuss financial parameters in advance.

Make sure you understand how your lawyer’s fees and billing system work, and who at her firm will be working on your projects. Ask your lawyer for an estimate of the cost of each significant project to be undertaken, and get assurances that you will be consulted well in advance if the project’s costs look like they will exceed that estimate. Ask your lawyer if her firm has special fee arrangements. For instance, some firms will offer special rates or deferred payment plans for start-ups.

Choose the right attorney.

Although your brother-in-law may be the best real estate lawyer in town and may be willing to do the legal work for the sale of your business for next to nothing, he is not the right attorney to choose. Go with a lawyer and law firm that has expertise in the area you need. Before hiring a lawyer, take a close look at his bio as well as the description of his firm on the firm’s web site. Feel free to ask him to describe similar transactions and other clients in similar lines of business (without giving away client confidential information) to assure you of his expertise and that of the firm. A lawyer who has experience and expertise in the area you need will end up being significantly more cost-effective and productive for your business, regardless of his hourly rate.

Give your lawyer feedback.

If there is an associate whose work you are not happy with, let the partner know. If you find the law firm’s invoices confusing, let the firm know. A service-oriented lawyer should solicit this feedback from you on a regular basis. But even if she does not, make your concerns known. You are the consumer, there are a lot of qualified attorneys out there, and your lawyer should care first and foremost about keeping you happy.

If you help your lawyer to provide cost-effective legal services by taking the steps outlined above, she can be a major asset to the health of your business, rather than just a necessary cost.

By Michael Oleksak

In the early days of my consulting practice, I met with the owner of a small manufacturing business. The owner had just learned he had inoperable cancer and confided that he would be dead in about six months. He did not have a succession plan but hoped his daughter, who was then 22 years old, would take over the business.  The owner wasn’t sure because he had not discussed this plan with his daughter yet.  Ultimately, the business owner turned to his accountant, who was also a close family friend, to oversee the transfer of the company to his daughter while the accountant stayed on as advisor. Because it was cancer, the owner had time to draw up a will and organize his estate.

His succession plan for the company, however, started with hoping his daughter would take over its management. His exit strategy had been determined by his health.

Prepare for Sudden Changes in Management or Ownership

Imagine you were this business owner’s commercial banker. Your small-business borrower drops this situation in your lap. Your first reaction is disbelief: This middle-aged man looks healthy. Then you become sad because you know and like this person.  But when you hear the owner’s succession plan is to hope he can leave the company to his young daughter, you wonder: “What experience does this just-out-of college daughter have?  Have I even met her?” This leads to more questions.

• How will employees react?
• How will customers react?
• How will you as a lender react?
• What is the future of this company?
• Will it stay financially healthy enough to repay the loan?

No question, the lender’s risk just went up. Should the interest rate rise as well? Is there a change of ownership clause in the loan agreement?  The owner’s terminal illness is not his fault. It is, however, his responsibility to prepare for eventualities like his own untimely death. His family, employees and company rely on his leadership and foresight to anticipate future issues.

By the same token, it is the commercial lender’s duty to ask tough questions to protect the bank’s position. Even if there is a change of ownership clause, you as the lender are in the same boat as your borrower. You want the company to succeed so the loan will be repaid or taken over at some point by another lender. No other lender will want to step in now unless the conditions can be improved with a defined succession plan along with increased collateral or financial support.

Understand the Owner/Manager’s Exit Strategy

Commercial lenders should address this risk by understanding the exit strategy of every owner/manager in their loan portfolios (if these owners even have an exit strategy).  The exit strategy will have a big influence on the strength of your credit as well as on the viability of your relationship with the company.

The exit strategy can lead to a conversation about whether the owner has a will and a succession plan. If the owner has not made a will, this could mean that ownership of the company’s shares is undecided or that the shares could land in the hands of under-prepared family members in case of the owner’s sudden death.

Case in point: Miami Dolphins owner Joe Robbie, a successful real estate attorney, did no estate planning before his death. His heirs had to sell the Dolphins franchise and Joe Robbie Stadium at fire-sale prices to pay estate taxes. The family fractured over the crisis, and Robbie’s legacy is not his successful real estate development career but the poor planning that harmed his family.

As a lender, you need to ask about an owner’s succession plan and whether the firm has the management depth and clear operational assignments to survive a surprising end to the owner’s life or incapacitation. A lender who asks these questions can prompt a business owner to develop a strategy and address shortcomings, thereby alleviating the lender’s concerns about unforeseen occurrences.

What are the possible outcomes for an owner-managed business besides the dire circumstances just addressed? Let’s look at two, both with different implications for the commercial lender: internal transfer and external transfer.

Internal Transfer

An internal ownership transfer could be (1) a sale to the management team, known as a management buyout; (2) a sale to employees via a tax-advantaged employee stock ownership plan (ESOP); or (3) a gifting of shares, usually to the next generation of the family, also with significant tax benefits. If the internal transfers are for less than 50 percent of the ownership shares of the company, the owner may stay in control of decisions and finances by controlling the voting stock.

Influence on relationship with lender. With an internal transfer, the lender should already be familiar with management if there is a change. With a management buyout, the lender should know the individuals taking over and must make a decision about whether the new team can lead the company despite the increased debt to finance the transaction. If not, the bank will ask to be paid out of the loan.

With an ESOP, the transaction will often be for less than the control of the company, a way for the owner to share with loyal employees by giving them an equity stake. A lender’s decision making should be the same, however, given greater debt on the books to finance the purchase. Gifting of company shares may be done in stages, so the current owner or management team may still be in control.

In all of these scenarios, what role will the current commercial lender play? No outside financing source will know the debt-service capability of the company better than the current lender, making it likely that the current lender will be the first invited to stay on to provide loans and services, including financing an internal transaction or ongoing operations.

All these scenarios could be subject to a change of ownership clause in the loan agreement, allowing the lender to opt out if not satisfied with the new ownership structure.

External Transfer

An external transfer would be a sale, either to a strategic buyer (such as a competitor) or to a financial buyer (such as a private equity investor). Because the external transfer will likely be for at least a majority of the shares, the owner will likely be out of the picture in a few years.

Influence on relationship with lender

With external transfers, it is likely that the private equity group or strategic buyer will have its own stable of lenders. By keeping the lines of communication open with the company and the prospective financing team, as well as expressing interest in taking at least a piece of the financing, however, the current lender may well have a role in the new loan or be kept on to provide some services.

Exit Strategy: Not Always Obvious

Commercial lenders are not often thought of as trusted advisors to a company’s business owners. Trusted advisors are generally the company’s CPA, attorney, and, sometimes, the owner’s investment advisor. The fault is not with the banker. Decades ago, the relationship was closer. However, successful lawsuits for lender liability cases have influenced lenders’ behavior. As such, lenders never want their actions to be interpreted by judges as having exerted undue influence over a borrower’s business decisions. Lender liability can result in big financial penalties against the lender.

For this reason, commercial lenders are often out of the loop when it comes to a critical factor influencing the strength and viability of their borrowers: the owner’s exit strategy. Much conversation between a bank and the owner-manager of a business focuses on the owner’s managerial role. It can be hard to get an owner to talk about ownership issues because these often require a discussion of personal and family issues. However, the owner’s exit strategy can have a huge influence on the health of the company and on the bank’s relationship with the company.

A good commercial banker provides numerous services to the owner-managed business, generating considerable fees for the lending institution. Apart from the fees and interest from the loan, the relationship probably also provides income for the bank from cash management services, trade services, account fees and balances.

Sometimes, when the lender is successful in engaging the owner in discussions of exit strategy, the loan and services may be lost anyway. Recently, a 12-store retail chain in the Northeast was sold to a large national retailer. Over the previous year, the lender had actively reviewed all the options facing the owner and the second-generation owners of the family business. In the end, the acquiror will pay out the family members for their shares, and the acquiror’s bank at the corporate level will take over the financing and services. Even with this outcome, the former lender had a good understanding of risk throughout the life of the loan and was able to anticipate some form of upcoming change.

Sources of Strategic Information

The lending officer typically meets regularly with the borrower’s chief financial officer, treasurer, vice president of finance, or controller to discuss the quarter’s results and trends. The lender can use these meetings to ask about ownership issues, including whether the owner has a will, who the beneficiary is regarding the company’s ownership, if there is a succession plan and whether or not there is an exit strategy. If the lending officer is aware of upcoming changes in ownership, the lender can protect the bank’s position as the preferred commercial lender.

The lender can help focus the owner-manager on the future by asking probing and thought-provoking questions about the owner’s will, succession plan and exit strategy. If the owner is reluctant to discuss these issues, the lender should take this as a signal that such plans may not exist.

If there is a board of directors, or board of advisors, the lender should ask these questions:

• Where will the business be in five years?

• Does the owner want to own the business in five years?

• Does the owner want to be managing the business in five years?

• Does the owner have a will?

• Who is currently the beneficiary regarding ownership of the company?

• Is there a succession plan if the owner gets hit by a bus on the way to work?

• Does the owner simply envision the spouse or other relative taking over if something happens?

Owners Want Their Businesses to Live On

Given the personal nature of these questions and their implied reminder of the owner’s mortality, these can be difficult topics to discuss openly. But the commercial lender is a key stakeholder in a business, and asking such questions protects the bank’s interest and capital.

Ultimately, most owners would like their businesses to carry on and thrive even after they are no longer active participants in it.

Creating and sharing details of a will, succession plan and exit strategy with their lender can help build toward a longer, successful existence for the business.

Michael Oleksak was a lender for 17 years at Bank of Boston. He is a principal at Trek Consulting LLC, Woburn, Massachusetts and co-founder of the Exit Planning Exchange. He works with small and medium-sized businesses to increase value and prepare for exit. Contact him at oleksak@ trekconsulting.com.  www.trekconsulting.com

© Copyright 2010 Michael Oleksak. All rights reserved.