In a closely held business, ownership always means far more than business value. Valuing your business will put a dollar figure on your business (and with any luck, it might even be accurate!). However, ownership of a business is about much more than the “number.” To many of our clients, ownership is about identity, personal fulfillment, developing a legacy, funding their lifestyle, and much more.
We explored the topic of what business ownership means on Wednesday, May 8th, in the final presentation of our value acceleration series, exploring how to increase business value and liquidity. In this final installment, we discussed the decision of whether to grow your business or exit, and which liquidity options are available for each path.
While it may seem counterintuitive, we find that it is best to delay the decision to grow or exit until the very end of the value acceleration process. After identifying and implementing business improvement and de-risking projects in the discover stage and the prepare stage (see below), people may find themselves more open to the idea of keeping their business and using that business to build liquidity while they explore other options.
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Once people have completed the discover and prepare stages and are ready to decide whether to exit or grow their business, we frame the conversation around personal and business readiness. Many personal readiness factors relate to what ownership means to each client. In this process, clients ask themselves the following questions:
- Am I ready to not be in charge?
- Am I ready to not be identified as the business?
- Do I have a plan for what comes next?
- Do I have the resources to fund what’s next?
- Have I communicated my plan?
On the business end, readiness topics include the following:
- Is the team in place to carry on without me?
- Do all employees know their role?
- Does the team know the strategic plan?
- Have we minimized risk?
- Have I communicated my plan?
Whether you choose to grow your business or exit it, you have various liquidity options to choose from. Liquidity options if you keep your business include 401(k) profit sharing, distributions, bonuses, and dividend recapitalization. Alternatively, liquidity options if you choose to exit your business include selling to strategic buyers, ESOPs, private equity firms, management, or family.
In our discussion about liquidity, we addressed several other topics that audience members were curious about. One of these topics was the use of earn-outs in the sale of a business. In an earn-out, a portion of the price of the business is suspended, contingent on business performance. The “short and sweet” on this topic is that we typically find them to be most effective over a two- to three-year time period. When selecting a metric to base the earn-out on (such as revenue, profit, or customer retention), consider what is in your control. Will the new owner change the capital structure or cost structure in a way that reduces income? Further, if the planned liquidity event involves merging your company into another company, specify how costs will be allocated for earn-out purposes.
We also discussed rollover equity (receiving equity in the acquiring company as part of the deal structure) and the use of warrants/synthetic equity (incentives tied to increases in stock price). Here are some of the key points from this discussion:
- Make sure you know how you will turn your rollover equity into cash.
- Understand potential dilution of your rollover equity if the acquiring company continues to acquire other targets.
- Make sure the percentage of equity relative to total deal consideration is reasonable.
- Seller financing typically has lower interest rates and favorable terms, so warrants are often attached to compensate the seller.
- Warrants are subject to capital gains tax while synthetic equity is typically ordinary income. As a result, warrants often have lower tax consequences.
- Synthetic equity may work well for long-term incentive plans and for management buyouts.
We enjoyed talking with business owners, management, and their advisors during this five-session series. We have found that through the value acceleration process, clients are able to increase business value and liquidity, giving them control over how they spend their time and resources.
If you are interested in learning more about value acceleration, please contact me. I would be happy to meet with you, answer any questions you may have, and provide you with information on upcoming value acceleration presentations.