The Five Most Costly Mistakes Made by Exiting Business Owners
By: Patrick A. Just, Investment Banking Associate
Most private business owners do not invest enough time developing an exit strategy for the sale or transfer of their business. The subject matter is typically delayed for both logistical and emotional reasons, including:
The burdensome time commitment required to support current business operations;
Lack of experience with merger and acquisition (“M&A”) transactions;
Uncertainty regarding the market value of the business;
Confidence regarding post-business cash flow and ability to support desired lifestyle;
Sense of identity loss from retirement and disassociation with the family business.
While many business owners cope with these pressures by simply ignoring the need for exit planning, the most successful investors contemplate exit strategies before a commitment to the business is made. For seasoned equity holders, maximizing equity value and realizing a successful transition from the business is the top priority, rather than an “unplanned potential eventuality.” With 80-85% of the average business owner’s net worth tied up in the illiquid equity value of their private enterprise, a hands-off approach to exit strategy presents significant risk to an owner’s long term financial well-being.
A passive approach can result in a substantial decrease in shareholder value and is often manifested in the following five most costly mistakes made by exiting business owners:
1. Letting the Good Times Roll
Unsurprisingly, the most costly mistake made by exiting business owners is waiting too long to begin the transition process. When asked about exit timing, business owners most frequently state that they are either looking to exit 3-5 years from now, or wishing they had exited 1-2 years ago. By nature, entrepreneurs are risk takers and regularly view the world through the rosy lens of future opportunities rather than focusing on the inherent risks that exist along the way. While this philosophy is arguably essential to their success as an entrepreneur, it can also lead to selling the business too late and at a much lower valuation.
The most successful exits at the highest valuation multiples occur during periods of extraordinary growth due to the market premiums placed on growing enterprises. As a result of this market effect, high growth enterprises can have a greater current value than at a later, less expansive state – even if cash flows are lower during the growth stage! Unfortunately, many business owners only begin to consider an exit after the expansion period has passed, or worse, with the business in decline. Owners of high-growth organizations should always weigh the valuation premium placed on their growing enterprise against the risk of sustaining business growth going forward.
2. Ignoring Market Dynamics
Private M&A markets, much like their public counterparts, are impacted by macroeconomic factors outside of the business owner’s control. Even in the case where a company is mostly unaffected by the greater economic landscape, market value will commonly rise and fall with the health of the overall economy. In other words, even good companies experiencing growth in a bad economy may hold less market value than the same business in a better market.
These market driven valuation principles are instinctively understood but seldom applied by business owners. Much like investors in publicly traded companies, business owners are more comfortable holding onto their assets when times are good and fail to view healthy economies as a positive signal with regard to exit timing. Business owners and investors who plan their exit strategies early are more likely to both recognize a strong market as an excellent time to garner the highest transaction value, as well as understand that even continued growth in the business may not overcome the loss of this valuation premium should the overall market weaken.
3. Engaging in One-Party Negotiations – “One Buyer is No Buyer”
As noted, the exit planning process is time consuming, complex, and outside of the expertise of many business owners and their executive management teams. Additionally, exit planning can be emotional and falsely viewed as planning for the end of the business. For these and other reasons, business owners may put off a sell-side process and simply wait until an interested party becomes more proactive in seeking to acquire their business. This approach appears to be less complex, less time consuming, and seemingly just as capable of producing comparable offers to those produced through marketing the business to a targeted group of interested parties.
While this approach may make sense to some, the lack of leverage resulting from one-party negotiations belies these assumptions. In a non-competitive environment, a potential buyer is under no pressure to move quickly, will often string along the business owner without making a serious proposal, and offer a significantly lower bid with less favorable terms than would be achieved in a competitive process. A carefully controlled M&A auction process maximizes valuation, helps ensure optimal terms, and extends the leverage of the seller by maintaining multiple competing bidders until a winning bid and exclusive party is accepted.
4. Pound Foolishness – Good Counsel Goes a Long Way
Saving pennies at the expense of pounds by neglecting to engage professional advisors in a business transaction process is one of the most costly mistakes made by exiting business owners. The services of CPAs, business attorneys, and financial advisors with M&A experience helps maximize transaction value by assisting in all phases of the process. These advisors will typically cover their fees many times over by advising business owners on the following transaction issues:
Prepares proper financial statements for M&A audience
Ensures correct adjustments are made to show the true cash flow producing capabilities of the privately held enterprise
Minimizes tax exposure to exiting shareholders by advising on tax treatment of the proceeds
Drafts asset or stock purchase agreement documents
Protects exiting business owners from financial liability associated with future performance of the business
Negotiates all final details of legal documents on behalf of the client
Identifies potential interested parties consisting of:
Financial investors with stated industry interest or current related investments, or
Similar businesses with competitive or regional strategic interests
Prepares all marketing materials used in conveying the strengths of the business to interested parties
Coordinates confidential competitive process and minimizes distraction from business owner and management team
Advises through negotiation process over valuation and terms
5. Insufficient Delegation – Impact of Under-developed Management Teams
Many business owners have a difficult time delegating power and authority. The combination of a protective concern for the business and a history of performing virtually every role within the company makes it difficult to entrust higher-responsibility duties to executive management teams. Though there is undoubtedly risk associated with assigning key roles to managers with less intrinsically aligned interests, the risk of a valuable enterprise relying too heavily on one individual is even greater.
Aside from the risk to the business in the event of a sudden loss of its key man or woman, the current valuation is also affected by failing to develop competent successive management teams. Buyers recognize that even if the previous owner has a stated intent to remain with the company post-transaction, his or her incentives are not as aligned with the overall business as they once were. Business owners considering a sale in the near future should begin by asking themselves, ‘how capable is my current management team of running the business in my absence?’
Managing the day-to-day operations of a business is burdensome enough and often makes the task of exit planning seem overwhelming. Working with advisors to identify the available exit options and the likely market valuation is a great place for an owner to start crafting his or her exit plan. In addition, avoiding these costly mistakes will place many business owners ahead of the competition when executing on his or her exit strategy.