Succession and Exit
Extracting Maximum Value on Exit from Your Privately Owned Business
Exiting your privately owned business is the equivalent of your own lifetime achievement award in business. And like any award, it does not happen by chance. To extract maximum value for your privately owned business requires careful planning. And when those plans are in place the key issues become, who are the logical buyers of my business and how much is my business worth. This article considers some of the important implications around these issues and their bearing on the size of your award.
You have grown your business from its humble beginnings from your studio apartment to its serviceable new premises housing plant, IT systems, IP and a band of trusted employees.
You have refined your business and its offering. Your business model is proven, your business strategy on track and documented for the benefit of your management team. Your market is well understood and your value proposition sufficiently different to your competitors that it is value creating for your customers and cost effective to your business. With governance structures in place, employees galvanised from a culture and practice of employee ownership, you and your fellow partners have removed yourself from working ‘in the business’ and are now contemplating exit.
In fact, your decision to exit was planned some time ago. It is only now that your structures and systems are in place, your goals for the business achieved that an exit is viewed as not just timely, but consistent with your overall philosophy and your willingness to exit.
The questions and issues that now occupy much of your time centre on the end game – who are the potential buyers for my business and how much is my business worth.
- The Order is Important
There is no circular reasoning here. The type of buyer will determine the magnitude of the final price. This outcome is a direct reflection of each buyer’s perception of risk and return.
There are many potential buyers of your business, but if we group all potential buyers from a risk and return perspective and consequently on their price propensity, ranking them from lowest to highest, the key buyers and transaction types comprise:
- Private to Private Transactions
- Private to Private Equity to Public/IPO
- Private to IPO
- Private to Public Transactions
- Private to Private Transactions
In private to private transactions, a private business is sold by one or more individuals to other individuals. These buyers might include family members or other privately owned businesses.
This is attributable to the following key factors:
Neither the buyer nor the seller is diversified. In most private firms, the owners tend to have much of their wealth invested in the private business and do not have an opportunity to diversify their wealth. At the limit, if the owners have all of their wealth invested in the private business the owners/investors are completely undiversified. That is, the owners are exposed not just to market risk of the fully diversified investor, but also to specific risks of the business. This means the cost of equity or the required rate of return on equity for private owners for investing in such a business is the highest of all investor types as they must seek a return to compensate for both market and firm specific risks.
High debt funding costs. Because of their lack of diversification, lower net worth and difficulty in tapping financial markets for additional equity when needed, private individuals are a higher credit risk to banks relative to other buyer types. A higher credit risk translates to higher funding costs necessitating a higher rate of return on capital invested for a private investor or a lower valuation and price for the business owner.
An illiquid investment. When you take an equity position in a business, shareholders generally like to have the option to liquidate that position if need be. The need for liquidity arises not only because of cash flow considerations but also because of the requirement to change investment positions. With publicly traded businesses, liquidation is simple and generally has a low cost – the transaction costs for liquid shares are a small percent of the share’s value. With equity in privately owned businesses, liquidation costs as a percent of business value can be substantial. Generally, discounts tend to be smaller for large firms and healthy firms with positive earnings and strong cash flow. The illiquidity discount is also likely to vary across potential buyers because the desire for liquidity varies with individuals. Buyers with ‘deep pockets’ and who see little reason to cash out their equity positions will attach lower illiquidity discounts to the price for similar businesses than buyers that have less of a safety margin.
Factors which increase the value of your business on a standalone basis and which can improve pricing on exit are control and synergy value.
The Value of Control. Most recognise that acquiring a controlling interest in any business, public or private carries a substantially higher value than if it does not provide this power. For privately owned businesses, this generally means that 51 percent of a private firm’s equity should trade at a substantial premium over 49 percent. This applies whether the business is being sold to a private entity or a publicly listed company and may also arise in an initial public offering (IPO). Due to shareholder dispersion, control in publicly listed companies can be acquired with stakes of less than 51 percent and are often as low as 30 percent where shareholder blocks are small. What is less appreciated, is how much control of a business is worth. Suffice, the value of control can be thought of as the difference between the value of a business optimally managed and its value run with incumbent management. It follows that poorly run businesses provide a larger premium for control than the same business managed and operated well. The value of control is the domain of the buyer. How much of this component a seller can realise is largely dependent on how the seller and its adviser can market the business and manage competitive tension, refer below.
The Value of Synergy. Synergy comes from merging two or more businesses and creating value over and above the value of the individual businesses combined. It is the classic scenario of where ‘1 and 1 makes 3’. Synergy value comes from reducing costs and/or taxes and increasing margin; generating additional revenues from scale, pricing power or entering new markets; and reducing the cost of raising new debt and equity capital from increased diversification and stronger financial capacity. Extracting value for synergy through an increase in price for your business is more difficult. This is particularly the case where the buyer’s business is largely responsible for generating the synergy. Clearly, no synergy value is possible where a business is sold as a consequence of a change of owners without the addition of a second and complementary business.
- Private to Private Equity to Public/IPO
This incorporates two scenarios where the private business is either partially sold to Private Equity which might also involve a capital raising on the way to the business going public. Alternatively, the private business is wholly sold to Private Equity ahead of it going public. Going public might entail a sale to a publicly listed company or an IPO.
Absent the issue of synergy, a sale of your privately owned business to Private Equity generally results in a higher price than one sold in a private transaction. This is because of higher levels of diversification of Private Equity investors and their lower debt funding costs and illiquidity.
- Private to IPO
This entails the sale of your private business by way of an initial public offering on a listed stock exchange such as the ASX.
An IPO is a viable option for a private business only where it has some critical mass, offers considerable growth potential which requires constant access to capital to fund that growth. The IPO option will not be viable for most private companies and given the considerable cost in obtaining a listing and ongoing compliance costs and public scrutiny, an IPO will also not be desirable.
Pricing in an IPO is generally at a discount to market to encourage investor take-up relative to other comparable listed alternatives. Additionally, if the potential for synergies is large, selling to a publicly traded business may result in a higher price than pricing via an IPO. An IPO is viewed attractive for some privately owned businesses due to the prestige of public ownership, the interest for continual involvement in the business beyond the IPO and the potential for uplift in market value as the business grows and attracts more investors.
- Private to Public Transactions
Private to public transactions involve the sale of your private business to a publicly traded business, such as one listed on the ASX.
These transactions can generally yield the highest price of all transaction options because of the diversification of investors, lower funding costs and levels of illiquidity.
The key difference between this scenario and a private transaction is that while the seller of the business is not diversified, the buyer or its investors are well diversified. A buyer which is a publicly traded business sees very different amounts of risk in the privately owned business with the seller seeing more risks (market and specific risks) than the buyer (market risk only).
Compared to a Private Equity buyer, a publicly traded business should attach no illiquidity discount since investors in a public traded business can sell their holdings on market. The cost of debt will also generally be lower for a publicly traded buyer.
The table below summarises the valuation and price drivers for each buyer and transaction type.
|Cost of Equity||Undiversified/low diversification, High cost of equity||Well diversified, Market cost of equity||Well diversified, Market cost of equity||Well diversified, Market cost of equity|
|Cost of Debt||High cost of debt||Market cost of debt||Market cost of debt||Market cost of debt|
|Illiquidity||High illiquidity||Moderate illiquidity||Low illiquidity, but a marketability discount||Low illiquidity|
|Control Value||Difference between optimal value and incumbent value||Difference between optimal value and incumbent value||Business at optimal at time of IPO||Difference between optimal value and incumbent value|
|Synergy Value||Potential where merge with complementary business||Potential where merge with complementary business||Nil||High potential|
|Value Impact||Lowest||Mid to High||Mid to High||Highest|
- Time the Market to Leverage a Favourable Price
On the issue of price and value, it is important to remember that there are two different processes at work in markets.
There is the pricing process, where the price of an asset (share, bond or house for instance) is set by demand and supply complete with the full array of behavioural factors that accompany this process, some rational, some irrational.
The other is the value process where participants attempt to attach a value to an asset based upon its fundamentals of cash flows, growth and risk.
What markets have shown consistently however, is that no one has a monopoly on good sense. There are winners and losers in all markets. Just as those who trade on price might be laughing all the way to the bank with the profits they have reaped from their investments, those same traders who view fundamentals and valuation as the reserve of academia should recognise that markets are fickle, mood and momentum change and fundamentals will matter sooner or later.
The implication for business owners looking to exit is that timing the market is an important determinant on value maximisation. A market in which conditions are favourable and prices are high, lifts the mood of buyers and investors generally. Pricing businesses on comparable companies in favourable market conditions tends to not only increase the prospect of their sale but also elevates their price.
Notwithstanding prevailing market sentiment, strongly performing businesses always command a price premium irrespective of the market. For such owners, seeking out the right type of buyer is of paramount importance, since as discussed above, certain types of buyers view risk and return differently.
- When Pitching a Business for Sale, the Story Matters
The real test of any valuation and pricing discussion is not just in the inputs or in the modelling, but importantly, it is in the story underlying the numbers and how well that story holds up to scrutiny.
A lot of people are sceptical of valuations and pricing models generally, and for good reason.
It is easy to hide bias in inputs and use complexity to intimidate those who are not as well versed in the valuation and pricing game. It is also easy to manipulate numbers to yield almost any value that you want and delude all in the process.
The real test of any valuation and pricing discussion is not just in the inputs or in the modelling, but importantly, it is in the story underlying the numbers and how well that story holds up to scrutiny. In a good pricing discussion, or at least one that is compelling, the numbers are bound together by a coherent narrative. That is, the story of the business is strongly tied with the numbers.
The key implication for business owners looking to exit, is that the Information Memorandum, the key document used to describe and inform prospective buyers about your business and its prospects needs to have a value narrative. This narrative should be factual, and when dealing with the future, plausible and probable. It should identify the drivers of value, the yardsticks that measure how the narrative is unfolding and change in response to unforeseen events, both positive and negative.
Similarly, for investors or business owners who are expanding through acquisition, the implications are just as profound. They need to find businesses that have compelling narratives, convert these narratives into value and make sure that they are not paying too much.
It is true that having a great narrative and the numbers to back them up is not a guarantee of investment success. The best laid plans of business owners can go to waste, but to not plan at all will guarantee that waste.
- There is No Substitute for Tension
The sale process typically is long (anywhere from 3 to 12 months) and will inevitably test your patience as you deal with the vicissitudes of potential buyers and their advisers. While this can be a source of tension, a tension any seller should embrace is competitive tension – the tension potential willing buyers feel when there are two or more bidders for the same business.
Competitive tension amongst willing buyers can drive rational pricing behaviour to its limits and often over step them causing a transfer of value from the buyer to the seller. Competitive tension does not just manifest in price alone. It can also manifest in favourable sale terms, whether it be in the size and scale of any earn-out or retention period. It can also be catalyst for the early consummation of a deal.
Even where there is only one genuine interested buyer, a properly controlled and conducted sale process can orchestrate the impression of multiple buyers creating the illusion of competitive tension with all the advantages it brings to the seller. This is a key reason for engaging an experienced adviser to assist you and your business through the machinations of the sale process.
- Closing Thoughts
The value of your private business on exit is inextricably linked to the type of potential buyer and transaction.
If you are the seller of a private business, you will extract maximum value on exit if you can sell:
- to a long-term investor,
- whose investors are well diversified,
- is well capitalised,
- has a complementary business providing the prospect of synergies, and
- in a buoyant market with favourable general economic conditions.
You will have a well-developed value narrative that closely ties your business operations with your financial track record and forecasts. Finally, you are well represented by an experienced Adviser able to orchestrate actual, or where there are limited potential buyers, the appearance of competitive tension.