Transition Strategies
There are over 2 million small businesses in the U.S. whose owners are aged 55 and over and nearing retirement. For sake of discussion, a small business is defined as having $0.5 to $10 million in revenue. Most of these small business owners lack a succession plan. Many do not have a family member or employee that is interested in or capable of running and owning the business. The small company typically has little excess capital. Few, if any, buyers are interested in acquiring this type of business. If there is a buyer, usually it is difficult for the owner to get a fair value for the business.
There are several possible sale exit strategies for a small company.
1. Inheritance – Family
2. Internal – Manager or Employee
3. Merger or Acquisition • Strategic Buyer
• VC with Successor
• Large Agency
4. Go Public
5. Newcastle Consolidation
Small business owner’s nearing retirement have different priorities. Most, however, seek the highest value for their company and highest return when selling their business without taking on too much risk. The best exit strategy to meet this objective may be surprising to most.
Inheritance or Internal
The first and second exit strategies involve selling to a relative or employee of the company. Traditionally, the seller and buyer enter into a contract where the revenues or profits are shared over a time period, under a Revenue/Profit Share formula, until the owner has received a certain ceiling amount of funds or royalties. The seller’s and buyer’s goals are aligned as the company’s culture does not change. The problem with this type of sale is that the company’s growth is limited. Growth capital typically is generated internally from business revenues The small company has limited access to outside capital, if any, to grow.. Its management is not usually skilled. And, the company’s market share is minimal. The seller’s return is totally dependent on the success of the company’s unskilled management over many years. Consequently, the sales price is low, the transaction’s risk is high, and the payout takes time.
Merger or Acquisition
The third exit strategy involves selling the company to a single purchaser, whether it's an individual or an organization, and whether its to a Strategic Buyer, VC with Successor, or Large Agency. The exit is typically through a merger or acquisition (M&A). This is the most common way businesses are sold as it is the least expensive way. The buyers have greater access to capital which is typically needed for growth. They also have access to new, skilled management that would ensure the company’s growth potential. If the buyer is from the same industry sector, then the successor company may have greater market share which would enhance growth rate. Traditionally, these buyers’ goals do not align with the entrepreneurs, and that’s were the problems lie that too often lead to an unsuccessful transaction.
The fundamental problem is that a small business entrepreneur’s culture is radically different than that of a large corporation. The small company’s entrepreneurial culture that provides the owner with control and freedom is not conducive to a large corporation’s culture thereby lowering its value and the buyer’s interest. If the large corporation has an interest, they usually want new management with greater skills for continuity with existing management. New managers will not have the prior owner’s relationships with customers, employees and suppliers and will change the entrepreneurial culture of the small business. This typical “Wall Street” acquisition model has failed in the past.
For companies that have a real upside at becoming a much larger organization, the seemingly least expensive route of merger or acquisition turns out to actually be the most expensive.
When small business owners are ready to sell their company to an outsider, traditionally they enlist a business brokerage firm to list it for sale like you would if you were selling real estate. Once the sale is consummated, the brokerage firm gets paid their commission and the owners get the balance of the sales price. Business brokerage firms are very good at knowing the geographical, economic and industrial environments that a company competes in and can be a true partner in getting the job done. But the selling transaction will most likely be with a single purchaser and could take a very long time. The smaller the business the longer the time as there are few buyers for small companies. It is simply not worth the time of a large buyer to invest in the due diligence of purchasing a small company.
The single purchaser transaction commonly involves a "Valuation Gap" problem. That valuation gap widens when selling to professional buyers, such as a Strategic Buyer, Venture Capitalist financing a Successor, or Large Agency such as Private Equity Groups. These are great M&A purchasers because they will pay cash - in relative quick fashion. They may insist that management remains active for a few years. The downside is that they discount the sales price seeking to pay less for more. Their job is to make sure that their investors receive as much value per buy/sell transaction as possible.
The good news is these M&A purchasers are typically flush with cash. It's called "Capital Overhang." There's so much of it they are starting to be less resistant to lengthy negotiations - (they'll acquiesce to your demands a bit more than they otherwise would.) And they are starting to lower their investment threshold from $15 to $25 million in annual sales.
But the bottom line is that these professional purchasers may purchase a small company for cash and relieve the owner from the possible burden of running a company day to day, as time goes by, but for the reasons stated above, if it can find a buyer, the small company may get substantially less than what its potentially worth.
No Quick Exit At Fair Value
In either case, the small business entrepreneur’s ownership interests cannot be quickly liquidated at a fair market value through a family or internal Revenue/Profit Share-based sale, or M&A transaction, or very quickly by taking the company "public."
Newcastle Consolidation
If a small company has real growth potential and is willing to join others and become one of several participants in a much larger organization, the fifth way of selling the company that involves consolidation and selling it to a large corporation or the public masses, should be considered.
Consolidation means merging the small company with other companies in the same industry sector, and most times same sub sector, to become a larger organization. As a larger corporation, with more revenue, earnings, capital access, and skilled management, the organization has greater growth potential. As a consolidation, the small businesses become more appealing to the public masses and a greater acquisition target of large corporations. The size as measured in revenue and EBITDA, management team expertise, and growth potential of the corporation (referred to as “Critical Mass”) matters as they create value. The greater the consolidated corporation’s value the higher market value and share price. How large the consolidated corporation can become in the future with an influx of new capital and management team members will also determine value.
A Newcastle Consolidation requires several small companies to exchange their stock for cash, stock and/or promissory notes. The stock small business owners receive is securities of the consolidated corporation. The consolidation takes place at a single merger closing event; thereby instantly creating a large corporation consisting of the combined revenues, profits, management and employees of several small companies. Each small company becomes a wholly-owned subsidiary of the large corporation. The consolidated corporation becomes a holding company of the small companies. With Critical Mass post consolidation, the consolidated corporation instantly has greater value. The holding corporation’s securities as formed by Newcastle may be publicly registered at consolidation or soon thereafter, -- creating even greater value.
Consolidation, however, requires integrating several small companies into a “well oiled” corporate machine. This means continuity among levels of management, agreement on “best practices”, policies and procedures, implementation of processes, systems, and technology, agreement on strategic plans for growth, and leadership at all levels of the organization. The entrepreneurs participate in the selection of the new, skilled management of the holding company, a lean executive team that has large corporate management expertise and “Wall Street” credentials. These professional leaders mentor the small business owners through the change and integration…transforming there business from an entrepreneur’s to a corporate culture. The success of consolidation largely depends on the success of entrepreneurs’ transformation to the corporate culture. Once this can be achieved, the successfully integrated corporation attains even greater value…as it is positioned for development, growth and synergistic expansion. The result…perceived value by the market, public, and large corporate buyers.
As a member of a large consolidated corporation, entrepreneurs can receive a much greater price for their company. Generally speaking, by being a constituent of a large consolidated corporation, a small company owner can command 3 to 5 times the value achievable in selling through the first through fourth exit strategies simply because it has greater Critical Mass as a wholly-owned subsidiary of the large consolidated corporation. The Critical Mass is key to creating value and becoming an acquisition target of a large corporate buyer. If the consolidation becomes a public corporation, a small company owner may achieve even higher value…as much as 5 to 12 times more. In addition, small company owners can become semi-liquid by borrowing against their public stock and liquidate their position over time thereby benefiting from a tax planning perspective.
Through a Newcastle Consolidation, the owner of a small company may earn more stock in the consolidated corporation over time and achieve greater returns. As the small company’s revenue grows and is shared with the consolidated holding corporation and as the entire enterprise’s value increases, the small business owner and employees earn additional equity in the organization according to a performance-based “earn out” formula and stock options. This causes the small business owners and their employees to remain active and committed to increase the consolidation’s value over the long term. Based on this commitment, market makers feel confident that the consolidated small businesses will have incentive to grow revenues and enhance relationships with customers and suppliers…the basis of driving financial performance and creating value.
Determining Valuation
Typically, a business will sell to purchasers (whether they are an M&A or a Newcastle Consolidation transaction) at a "Multiple" of revenue or Earnings Before Income Taxes, Depreciation and Amortization (“EBITDA”) plus the appraised value of any real estate and real property applicable to the business. Most buyers would prefer to eliminate real estate and any personal real property by transferring title via Quick Claim to the business owner. Other standard variables such as the business’ prior year revenue growth rate, short and long term liabilities, and management retention affect the small company’s valuation. Variables specific to the industry sub sector may also alter valuation.
The next important thing is the Multiple of earnings. Typically, small privately held companies will sell at .8 to 1.2 times revenue or 3 to 5 times EBITDA. The Multiple is dependent on the industry sector. A Multiple of 3 to 5 times EBITDA is also known as the "Price Earnings (PE) Ratio."
There is an unlimited way to determine the price earnings ratio in a private market, but only one way in a public market. The public market will determine the PE ratio through basic supply and demand, so the small business owner doesn't have to be concerned about setting an arbitrary PE Ratio.
Of course one should always try to improve the PE Ratio, before the sale. The higher the revenue growth rate the higher the PE Ratio, the higher the sale price. The only way to increase a PE Ratio is to increase the growth rate of revenues and lower expenses, now and into the future. Yes, you can use pro forma financial projections to conservatively estimate the annual revenue growth rate, with or without additional management and or additional capital. However, illustrations of growth rates using GAAP compliant pro forma financial projections with an influx of new management team members and additional capital is a very positive catalyst to determine the PE Ratio, which becomes an added advantage to ultimately increasing the sale price.
Transition Services
Once the small business owner realizes that Newcastle Consolidation is the best exit strategy, it becomes apparent that the small company owner cannot efficiently run the business at hand, raise capital to create a successful consolidation or go public, and navigate the rough waters of these time consuming transactions and the ensuing entity. Fortunately, Newcastle manages the entire process.