Exit and/or Recapitalization
Exiting your business or buying out your investors represents the “payday” for your efforts and risk after many years as searcher/CEO. It may or not mean that you will step away from the business, but this milestone will likely mark a new chapter in the life of your search. Each searcher must regularly examine when and how an exit makes sense for them and the business – well before the actual event. As with many things in business and life, “timing is everything”, but your personal and professional preferences can be a driving factor.
A dozen recent searcher/CEO’s reflected on the decisions they made regarding their exits or recapitalizations and were willing to share their experience with others who may consider following in their footsteps. All, for obvious reasons, requested anonymity. Their lessons learned should be useful in setting your own path when it comes time for you to to consider this step.
When is the right time?
Several factors will influence the timing of this significant decision. Market conditions continually evolve, and selecting the point “just before” a decline is optimal. However, individual searcher preferences come in to play as you mature, possibly become less challenged, and think about the prospects of a longer-term commitment to the business. Often, the future needs of the business coupled with the financial expectations of the investors may drive this decision.
For many, external market conditions dictated the timing, as one searcher/CEO pointed out, “we found ourselves at a state of the market when there were seemingly astronomically high M&A multiples, the industry segment was hot and there was lots of capital looking for deals.” Or for another, “we received an unsolicited offer that was surprisingly high which inspired us to retain an investment banker to test the market further.”
Being sensitive to the time horizon of investors, one searcher/CEO observed, “had the opportunity to lock-in an out-sized gain for our investors and ourselves.” In another, a “fund of funds” investor was anxious to close out their position, despite other investors willing to wait. Another says about their timing, “we were approaching the later stages of the investment hold period and evaluating whether the outcome be a financial win for our investors.” A self-funded CEO reflected “Strong performance plus strong credit markets made the time right to recap my investors and own 100%. It was an easy conversation with all as it was a good, fair deal.” Finally, one remembers, “the investment group was divided about the timeline for the future. There was a good banking climate and I was able to cash out for a good return those who wanted to be cashed out, but it came with having to sign personally on the debt.”
An inward examination of the company and its progress resulted in one CEO saying, “there were execution risks inherent in bringing company to its next phase of evolution and the time horizon to achieve it was over the 3-5 years.” One recalls, “I had come to recognize that our growth was more capital-intensive than expected.” Also remembering, “it was an inherently cyclical business without having experienced an economic downturn and we felt it was an optimal time.” In another situation, “we brought in a senior operating manager was brought in an who wanted to become a shareholder of the business which represented a succession plan for us; in retrospect that early hiring decision set the stage for our exit.”
On a personal level, assessing how you are feeling about your own development is an important consideration as one searcher reflected, “I regularly evaluated if I was adding value at a high level and if it was something I wanted to keep doing, or, was I interested in new challenge.” Facing a further commitment weighed heavily on this searcher/CEO team, “we did not want to risk experiencing an economic downturn that could have resulted in our remaining in the business for another 4-5 years.”
Your individual financial situation may come into play, especially given the economic incentives around IRR targets, which become more challenging to achieve without large exit multiples. A searcher felt, “At a personal level, I wanted to de-risk and diversify by taking some chips off the table after ~6+ years of searching and operating – since 95% of my net worth tied into highly ill-liquid asset.” In any case, it is a good practice to have this “exit” conversation at least once a year, even if it is with your own “mirror” to avoid looking back and wishing you had decided earlier.
Key decisions to make
Most searchers regularly discussed a future exit with their board and one searcher reflected, “I spent over a month on a spreadsheet comparing value of selling now versus growing for a few more years and discussed the scenarios with the board.” Another remembered, “we had to fight hard with the board on accelerated vesting for management team, which is pretty common in VC ventures. The dilution would come out of their pockets and they were resistant to this type of ‘carve-out’!” A self-funded searcher remembers, “It just felt like the right amount of time to give a return to the investors and proceed on my own from internally generated cash flow.”
A significant decision was about how long to continue in a leadership position, as cited by a searcher, “I had to decide just long I was wanted to stay post-sale and more importantly how to be direct with buyers about my willingness to stay. It impacted how we thought about the financial buyers who wanted me to stay and roll some of my equity.” Another searcher struggled with the balance of, “communicating the explicit desire to reduce my rollover as much as possible while simultaneously conveying enthusiasm and conviction about the future and advocating for an early departure.”
Launching a “process” to move toward an “auction” is a benchmark practice. A CEO says, “I had to confidentially reach out to a number of Investment Banks and select 2-3 to ‘pitch’ their ability to take us to market and estimate the potential outcome we might see.”
Once the decision was made, searchers reported a range of 3 to 12 months and an average of 7.5 months. However, one said “it is generally safe to assume that it will take longer than you think it will!” The cost for an M&A advisor was in the 3-5% range of the sale price.
Rolling equity and staying on
Most searchers reported mixed feelings about rolling equity from the exit with a new set of investors. On the positive side, one searcher says, “I knew that it would raise valuation. I believed in the company and felt like I was selling something of quality which emotionally felt good.” Another expressed, “part of me wanted to roll as little as possible, not necessarily because I didn’t believe in the future of the business, but more because I had always envisioned an exit as exactly that – a full exit!” One searcher/CEO was very clear from the beginning of the process, “I did not want to work for a private equity firm any longer than necessary to facilitate a smooth transition.” Another said, “luckily our highest value buyer was a Strategic, so our interests aligned with theirs on rolling and staying on for only a short time.”
While the investors may have a point of view about your future engagement with the business after sale, one searcher expressed, “I felt obligated to do so for my investors. In hindsight, I don’t think they expected me to do it. I think there is an element of ‘good steward’ that we all carry very sacredly – which is, of course, a good thing for the business, but in this particular circumstance I think searchers may take it farther than we need to.” Another found that, “you need to know if you want to stay or go. It makes everything much cleaner if you can say with conviction what you want – making it known before embarking on the sale path.”
There were concerns expressed by searchers such as, “we could always use more cash to buy another company. Actually, we did see 3-5x over our roll-in amount!” Another felt, “I was tempted as it could represent a ‘best of both worlds’ scenario; where on one hand I achieve liquidity, and on the other hand still have additional meaningful upside moving forward.”
Once the decision is made on this critical deal term, it is important to obtain full investor buy-in and to make both the M&A firm you select and the potential buyers aware of the choice. A successful searcher reported, “we were open with our investors that one of our objectives was minimizing our rollover, and they were supportive of that. Thankfully, it did not appear to have hurt value.”
The prospect of “taking money off the table” and continuing to be engaged in the business without as much personal risk and an opportunity to gain some additional upside is very seductive. After all, who knows the business better than you. Your ego may get in the way of assessing this in a rational way. Many owners find it more difficult than they imagined to give up control. More significantly, they discover that having a “boss” again is not as pleasant as they thought. Watching the decision making process and its impact on an enterprise that had been “yours” is difficult. One SME says, “within six months, I knew I should have taken a slightly lower price and simply been free to start off in another direction without the emotional ties to the business over which I had very little control.” This owner had gone from being a MIP (Most Important Person) to being a PIP (Previously Important Person)!
Keeping it quiet
All searchers thought carefully about avoiding leaks in the process and undue speculation about their intentions. One searcher/CEO says, “we brought managers under the tent fairly early and tried to be smart about it with secret closed-door meetings-in our accountant’s office, or meetings in our conference room with no windows. I never had to lie to employees and once under LOI, opened up to all employees with caveat that we’re exploring a new equity partner to help grow.” Another said, “we always kept doors closed on calls, had meetings with buyers off-site in motel conference rooms and utilized a code name. To ensure that the management team kept things confidential, I told them that they were being entrusted with this very important information, and that I knew that level of trust was well-placed.”
One searcher/CEO struggled with when to communicate with his management team, “soon after the board approval to proceed, I met with each individually, then brought them all together to address their concerns. Surprisingly, they were more interested in supporting the process than ‘blaming’ me for the decision. I wanted to insure it would have minimal disruption on the business and employees.” Another simply said, “Telling my management team early was the best thing that I could have done.” Understanding the culture of trust and openness that exists in your operation will help sway this decision one way or the other.
A few chose to keep the entire process quiet and orchestrated the announcement at sale, saying “prior to sale, we simply didn’t say anything to anyone. Post sale, we edited the private equity firm’s press release and made sure the wording was “recapitalization” as opposed to sale or exit.” One observed, “this is hard to do, especially when you run an operation where you have visitors infrequently and then all of a sudden have potential buyers in suits roaming around. We positioned it to employees and suppliers as looking for new investors to help fund growth.”
For vendors, clients and other outsiders, one searcher remarked, “we fought like mad to keep customers in dark until the last week before closing…market noise is a hard one to get back in box, and we did not want that.” Another simply made it clear up front, “we set the expectation early with buyers that there would not be access to employees. To avoid too much ‘market leak’, the process included the obvious, but limited set of buyers.”
Taking steps to prepare
Selecting a competent M&A advisor is a critical step and observing the transactions in your industry over the years should give you a solid list of potential brokers and investment bankers to reach out to as you initiate your own process. A searcher/CEO emphasized, “make sure you vet them extensively. It’s particularly important to understand the typical deal sizes that your banker handles and make sure that you fall within their sweet spot.” Another said, “nobody wants to hire the ‘discount’ eye surgeon!” And finally, another says, “never head down this path with just one suitor, always get multiple bids.”
Avoid fixating on a “price”, since the market determines the value your business will bring. The M&A advisor will provide a “range” and it may be impacted by the “terms” more than you think. More importantly are the terms of the transactions that you know so well from you own negotiations with sellers. Spend some time with your accountant and tax attorney understanding both the short and long term obligations and timing of the cash flow into and out of your personal account.
Preparing a “data room”, with accurate, detailed and complete financial and market information will be critical to the sale process as you know from your earlier search experience. Installing a robust, accrual-based accounting system better prepares you for exit. As one searcher pointed out, “you should be preparing for sale from day one. Quality and quantity of information that you have on hand needs to be in top shape before you consider selling, which isn’t something you prepare for as much as it’s something that you always do!”
Over the years, it is important to develop a relationship with multiple potential acquisition targets. These “frogs”, kept in your pocket, are attractive to buyers and represent value beyond your EBITDA and multiple. Likewise, regular outreach to potential strategic acquirers, or “toads”, also have value as you start the process. One searcher says, “we lightly built relationships with potential acquirers leading up to process.” Another reflected, “we had one eye on exit even before we had acquired the business and met with competitors early on to see if they were likely buyers and their acquisition criteria.”
As early as 18 months prior to sale, you will want to “trim the sails”. Prune off programs that are not yielding progress, evaluate your weaker personnel and staff. The “trailing twelve months” of EBITDA (TTM) will be a critical measure of your financial health and should be well “scrubbed”. Another searcher stressed the importance of “shifting from focus on systems to focus on growth opportunities and new markets and to build a strong sales pipeline.” You will need to change your role, as a searcher pointed out, “I had to turn attention to the financial structure of the company rather than just having my head down and operating the business.”
You will want to have accumulated a competent management team that is focused on their future. One searcher was clear, “you need a high-functioning management team before you consider selling. If the business is too reliant on you, it will either be a huge barrier to exit or will lead to a sub-optimal outcome.” A second searcher/CEO said, “run the business for value creation. This way you never feel ‘slimy’ and you can look your team in the eyes when you talk about growing their careers and giving them advancement opportunities.” And finally, one was able to “provide each member of my management team a financial benefit from the transaction.”
Avoid the temptation to fantasize about what you would do next and how you will spend your time. This distracting self reflection may cause you to lose focus on running the business on a day-to-day basis and having the awful experience of seeing a decline in revenue or cash flow in the middle or toward the end of the process. Instead, leave yourself a year of “white space” after you have left the business to contemplate your next chapter of life and career – you deserve the break!
As with much about search, each acquisition and subsequent exit/recapitalization is unique. However, there are some common themes that searcher/CEO’s felt important to pass along. One of the searcher/CEO’s advised, “understand the exit process well. Dialog with at least a half-dozen CEOs who have been down this path ahead of you.” Another felt, “our final outcome wasn’t what we thought at the beginning. Understand that the process shapes the outcome as you learn your options.”
Despite having been on the “other side” of this sale process, be prepared, as a searcher says, “there is not a lot of “truth”, buyers and prospects will drop out for any reason or for no reason, and you’re often not aware of the real reason why anybody declines. Despite what you may think about valuation, the market drives it and you may see 2-3x range of offers with wildly different terms. Don’t lock in on a target price, let the market assign the price.” Another says, “don’t take your eye off the business during the process; if you miss your numbers during the process, it makes your life a lot harder.” Finally, one long time search investor observed, “once you start ring shopping, you will buy the ring.”
Your investors are important in this process also, but as one searcher advised, “management has way more power than investors. Don’t let a ‘lead’ investor push you around assuming the majority really want to sell.” Another searcher advised, “before you start the process is also the right time to discuss a transaction bonus if you expect that the net proceeds you will receive are inadequate to entice you to transact. Be warned though, this will not be a fun conversation! But, your chances of success are vastly greater before the process has begun than toward the end.”
Most searchers say the process takes an emotional toll, somewhat similar to the challenges of the search and closing phase of their original acquisition. One observed, “expect there to be significant emotional ups and downs. Your view on the likelihood of a deal happening changes weekly. It is exhausting; you will have 2 full-time jobs, your ‘day to day” responsibilities and sale process. One or both of them will almost certainly slip despite your best efforts.” Another found, “after spending all day ‘selling’ other people on the art of the ‘possible’, this process can ’make you fall back in love‘ with your company and its future prospects.”
All searchers have learned from the prospecting phase of the search process, that sellers are almost always better off “holding on” to their business than selling it, unless they are too old or have some other reason. Generally, search investors have a long-term horizon, but there is strong evidence that the searcher/CEO can drive this decision for personal reasons sooner in some cases.
As with much of search, reaching out and connection with other searchers who have been through is a great way to navigate through your own unique situation.
Feel free to share some of your own best practices or experiences in dealing with these issues in the blog comments. I encourage comments and dialog, allowing all in the community to learn from both my views and the views of others – a virtuous learning cycle. Jump right in! I frequently update individual b log posts, add to the Reference section and Search tips, so visit www.jimsteinsharpe.com website regularly.
Jim, do you have any thoughts around how one should use an ESOP upon initial acquisition to help align key management towards maximizing exit possibilities? When I ask this, I’m assuming a self-funded search (and so would control a large stake in the company).
Kennedy, using an ESOP as a financing mechanism is rare; I know of only one instance I know of that goes back to 2001. Investors in a funded search would not want this option. A self-funded searcher may be able to negotiate the challenging requirements of and SBA loan as described here. Most searchers, however, find other ways than “equity ownership” to align the organization as the business grows; equity seldom pays for groceries! Instead, cash compensation tied to EBITDA performance and growth work well along with an overall leadership philosophy emphasizing just doing the “right things” for the business. Be prepared to understand this option as I do here it come up from time to time when a seller engages their accountant to review your LOI and to understand the tax consequences of a sale.