The Entrepreneurial Lifecycle traces the natural progression of building a company. All along the way, entrepreneurs constantly ask themselves and others about ways they can make their company more valuable.
The Entrepreneurial Lifecycle starts with building a team of trusted advisors. The best teams are multi-disciplinary in nature covering a spectrum of expertise relevant to the company. While having the entrepreneur’s best interests at the forefront, these advisors provide guidance and complement the entrepreneur’s natural talents and skills. Assembling the right team of advisors can make a huge difference in the ultimate success of a company.
Style of Company
One of the early choices an entrepreneur makes is the style of company he or she wants to build. Company styles fall along a continuum ranging from lifestyle companies to equity growth companies. One style is not better than the other; the selection of a company style simply reflects the preferences and objectives of each entrepreneur. The major difference between the two ends on this continuum is that equity growth companies are built to be (eventually) sold. Entrepreneurs building equity growth companies view the business as an investment in which they are creating a valuable asset.
Five major lifecycle stages characterize the growth cycle of companies.
- The Startup stage (revenue between $0 and $1 million) represents the birth of a company and is where the entrepreneur’s grit and drive brings an idea to life. The product or service takes shape and is validated in the marketplace by customers willing to pay for it. Employees are hired, suppliers are selected, and operations are put into place.
- The Startup Breakout stage (revenue between $1 million and $3 million) is where the entrepreneur commits to building a larger company. More employees are hired, selling methods are refined, business relationships are extended, and an unyielding focus on satisfying customers resonates throughout the company.
- The Emerging Growth stage (revenue between $3 million and $10 million) is when the company’s product or service really takes hold … and entrepreneurial risk is further tested. More customers lead to more employees, greater reliance on suppliers, and overcoming operational challenges to scale the business.
- Breaking into the Lower Middle Market (revenue between $10 million and $100 million) is a hallmark that, frankly, relatively few firms obtain. A “whole company” is now built-out as the organizational chart expands into various functional groups, more products and services are brought to the market to satisfy the needs of an expanding customer base, and operations are made more versatile and resilient.
- The Middle Market (revenue between $100 million and $500 million) sees a much broader company with deep penetration into markets they are able to serve well, grow, and defend.
Knowing what their company is worth is probably the single most important piece of fundamental knowledge for entrepreneurs. The economic value of a privately held company can be calculated in a variety of ways based upon combinations of assets, income, and market forces. While the price for a public company is only a ticker away, that is not the case for private companies. An entire professional field is devoted to “business valuation” and a company’s value can vary depending on the purpose of the valuation (i.e., taxes, probate, loans, buyout agreements, legal settlements).
The “market value” of a company is simply what someone is willing to pay for the company that the business owner is willing to accept. Unfortunately, it is not straightforward to calculate. This leads many entrepreneurs to rely on rules of thumb to estimate the value of their company, which can be very misleading. We can look to Warren Buffett, who knows a thing or two about valuing a business, for guidance: the value of a business resides in the company’s ability to generate future cash flows that can be taken out of the business after adjusting for time and risk. This figure is referred to as a company’s intrinsic value and it is the proper way to value a company.
The challenge lies in constructing a model that reasonably estimates these future cash flows. The model typically takes the form of a 5 year pro forma that forecasts a company’s income statement and balance sheet. But this is more than a mathematical exercise. Properly building a 5 year pro forma requires analyzing the competitive environment, understanding the strengths and opportunities the company possesses as well as the weaknesses and threats the company faces, and evaluating the dynamics of the industry and markets in which the company competes. Knowing your company’s intrinsic value gives you a strong baseline to measure your progress and to better understand what creates (and destroys) value.
Increasing the value of a company is every entrepreneur’s ambition, but many forces are at work impeding this pursuit. Identifying and influencing these forces – some of which the entrepreneur controls and many of which the entrepreneur must figure out ways to respond to – is what separates companies who are able to grow in value from those that hit a plateau.
Capitalism is a demanding scorekeeper. Fashioning a well-integrated business model, properly segmenting and defining addressable markets, specifying a growth strategy and executing against a plan, and measuring your performance against rivals are fundamental requirements of a competitive landscape that is global in proportion. Collectively, this forms a company’s investment thesis. This investment thesis is the basis for creating a company’s core equity value, which is the premium someone pays for a company over and beyond the book value of assets that are shown on the balance sheet. A company increases its core equity value through strategic positioning, market development, sales execution, and operational excellence.
Determining the right time for an exit is influenced by many factors. A case can be made that prudent companies should always be well prepared for an exit because the owners never know when an offer may come their way that could turn into an outstanding result. The discipline of being well prepared helps keep the company focused on building value and executing solid business practices.
Getting the company ready to sell increases the value of the company as well as increases the likelihood of completing a transaction on good terms. The optimum time for an exit is influenced by the lifecycle stage of the company, industry conditions, personal needs of the entrepreneur, desires of co-owners and investors, the regulatory environment, the broader economy, and the public capital markets. When the timing is right, entrepreneurs should invest the same intensity and commitment to planning and executing their exits as they do to building their businesses. It is important to determine both the personal and the corporate objectives of the entrepreneur so that the focus is on the overall “transition” and not just the exit transaction.
It is prudent when planning a seven to eight figure exit to have a comprehensive financial plan. This plan should show the path to financial security as well as addressing the more aspirational aspects of what is important to the entrepreneur: leaving a family legacy, spending more time with people you love, pursuing interests you enjoy, making a difference to people and causes you care about, and – if the entrepreneur is so inclined – starting the process all over again. A comprehensive financial plan will also help in determining how a transaction should be structured. After all, it is not just how much the entrepreneur gets paid for the company that counts, but how much he or she keeps after taxes, fees, and the amount of funds still at risk that really matter. Consequently, exit planning requires a diverse team with multifaceted skill sets collaborating with each other and keeping the best interests of the entrepreneur at the forefront.
When the time comes to prepare for an exit, the first critical steps are knowing your options and assembling your exit team. Ideally, this team is composed of several of the entrepreneur’s existing trusted advisors who know both the company and the entrepreneur well. The word “trust” is emphasized here because exit transactions, especially for mid-size companies, are complex affairs calling for a multitude of decisions to be made under pressure with far reaching implications in a relatively short period of time. Good transactions are put at risk if the entrepreneur questions either the competence or loyalty of his or her advisors. Putting together a skilled and experienced transaction team the entrepreneur can trust is an essential step to executing an exit transaction in an orderly manner.
Four roles are particularly important for exit transactions:
- The M&A attorney is a lawyer who specializes in negotiating business transactions involving a change in ownership. Good M&A attorneys find ways to get a deal closed while preserving the best interests of the entrepreneur. Frankly, some attorneys have a tendency to throw up roadblocks and delay decisions. M&A attorneys are adept in finding ways around impasses and getting transactions closed under tight timeframes.
- CPAs help validate and explain the company’s financial records. It is typical for sophisticated buyers to hire well known accounting firms to perform a “quality of earnings” analysis of the company’s financial performance and records. Having a good CPA on the team provides a critical resource for clarifying the company’s accounting practices and records.
- Tax specialists are often brought onto the team to analyze and provide guidance regarding the tax implications of various deal structures. Tax specialists can be associated with either an accounting firm or a law firm.
- Transaction intermediaries take the form of either “investment bankers” or “business brokers.” The primary functions of transaction intermediaries are to identify potential buyers, assist the entrepreneur to select the “best and preferred buyer,” and driving the process forward to get the deal closed. At first glance, business owners may believe they already know who the “best” buyer is: a competitor, supplier, or a customer. In many cases, however, the best buyer is not known to the business owner and this is where the expertise of transaction intermediaries enters the equation. As a general rule, business brokers specialize in finding buyers for companies with $5 million or less in revenue while investment bankers are used for companies with more than $10 million in revenue. Not all transactions require an investment banker or business broker (family successions, selling to management/employees). Several factors influence whether or not to use a transaction intermediary, but in the right circumstances investment bankers and business brokers can add considerable value.
With the transaction team in place, augmented by other advisors as necessary, planning the exit begins in earnest. There are five key components to planning and executing an exit.
- Exit Options: At the heart of a transaction is the transfer of ownership interests in the company. There are seven exit paths available to business owners:
o Transition ownership to a family member
o Sell to a co-owner
o Sell to employees
o Sell to a competitor, supplier, or customer already known to the business owner
o Sell to a strategic buyer (a larger company)
o Sell to a financial buyer (a private equity firm)
o Wind-down the company and liquidate
All are viable options. Depending on the underlying fundamentals of the company and current market forces multiple options may be available for consideration. Based on the preferences, needs, and objectives of the business owner, the preferred exit option is selected. Each particular exit option stipulates a specific course of action and the skill sets needed on the transaction team.
Financial and strategic buyers form a special group of prospective buyers and make up the “Private Capital Markets” (in contrast to the “public capital markets” such as the New York Stock Exchange and NASDAQ). These sophisticated buyers specialize in acquiring companies in the Lower Middle Market (revenues between $10 million and $100 million). The ability to access the private capital market significantly expands the scope of potential buyers who are willing and able to pay for the company. (While an Initial Public Offering is another exit option, IPOs account for only 1% of market transactions compared to the Private Capital Market.)
- Exit Structure: Once the preferred exit option is selected, the transaction team defines the “preferred” structure for the exit. The word “preferred” is used because the final transaction structure is the result of negotiations with the buyer. The transaction team starts with a clear understanding of what is important to the entrepreneur and where there is room for negotiation. In broad terms, transactions are structured as either an “asset sale” or a “stock sale.” The proceeds of the transaction can be packaged in numerous ways, each carrying tax and future risk implications: cash, stock, seller notes, warrants, earn-outs, non-competes, royalties, etc. However, what benefits the seller may be detrimental to the buyer. Understanding the implications and impacts on each party’s position and reaching middle ground across a myriad of points – many of which are quite technical in nature – is what gets hammered out negotiating the purchase agreement.
- Exit Type: There are three types of exits: total sale, majority recap, and minority recap. These exit types form a continuum from a small minority interest to total ownership creating a trade-off between liquidity and control.
- Total Sale: People typically equate exits with the total sale of a company. This gives pause to many entrepreneurs who think that only two options exist: either sell the entire company or keep working. This is not the case. The total sale of the company makes sense when the business owner wants to maximize the proceeds from a transaction and is ready and willing to let go of the company. Depending on how the exit is structured, the business owner may still be affiliated with the company for a period of time after the transaction, but for all intents and purposes the company belongs to new owners.
- Majority Recap: A majority recap is a viable option for an entrepreneur who still wants to work and continue growing the company, but would like to take some “chips off the table” to diversity his or her net worth. With a majority recap, buyers own the majority of the company and, consequently, control the company. The entrepreneur, however, still retains a significant ownership interest (typically in the range of 15% – 40%) and is positioned for the “second bite of the apple” when the company has its subsequent exit (typically in 4 – 7 years). A majority recap can be the best path to maximize the total return on the company.
- Minority Recap: A minority recap is an option for entrepreneurs seeking growth capital to fund expansion strategies and acquisitions. Strictly speaking, minority recaps are not exits per se since buyers of the minority interest in the company desire their funds to be used to fuel growth strategies. However, depending on the situation and the lifecycle stage of the company, some of the cash could be distributed to the entrepreneur. Majority and minority recaps are typically the province of financial buyers (private equity, venture capital, and hedge funds) although many corporations will also make recap investments. Both strategic buyers and financial buyers purchase companies in total, although strategic buyers represent 75% of these acquisitions.
- Exit Strategy: After determining the exit type, the next key decision point is determining the exit strategy to employ. There are four major categories of exit strategies: arranged marriages, preemptive bids, narrow auctions, and broad auctions.
- Arranged marriages work for all seven types of exit options and are characterized by a buyer and a seller agreeing to enter into negotiations and working out the details of a transaction. Each exit option has its own nuances, which has a bearing on the skill sets that are needed on the transaction team. Tax implications and unintended consequences weigh large. Transactions with family members can affect family dynamics in subtle and not so subtle ways. Transactions with co-owners may be governed by buyback and first right of refusal provisions. For mid-size businesses, ownership can be transferred to employees in a variety of ways including using an ESOP, but there are a lot of details to address setting up one of these plans. Transactions involving competitors, suppliers, or customers already known to the entrepreneur can be dicey given ongoing business and competitive relationships. One of the significant challenges of an arranged marriage is determining the purchase price of the company. It may seem strange at first that there is not one “single price” for a private company. In many cases, the value of the company is in the eye of the beholder as well as what the entrepreneur is willing to accept. A company, for instance, could be valued lower if it is being sold to a family member versus being sold to a competitor. The process of determining “fair market value” involves the buyer and seller agreeing to a specified amount as well as how the payment will be structured. Knowing the company’s intrinsic value that is reasonable, defensible, and documented is a vital piece of knowledge for the transaction team when negotiating an arranged marriage.
- A preemptive bid is an alternative to selling the company using an auction process (explained below). A preemptive bid is negotiated with a financial or strategic buyer to achieve an outcome similar to what would be achieved by an auction process, but without going through the rigors and expense that auctions require. Both parties agree to negotiate in good faith. If the business owner senses that the potential buyer is holding back and not being as forthcoming as they would in an auction, then the business owner always has the choice to break off negotiations and “take the company to market” via an auction. This ability to use an auction if necessary provides the entrepreneur with a degree of leverage to ensure negotiations are kept on track and above board. The benefit of a preemptive bid is that a deal can be done faster and with less wear and tear on the entrepreneur and the management team compared to an auction process.
- A narrow auction targets only a relatively few financial and strategic buyers who appear most likely to be interested in buying all or part of the company. It takes skill and special resources to identify these candidates. The intent is to create a “competitive deal environment” consisting of multiple buyers each competing against the other to offer the best purchase price and deal structure. This competitive process lets “the market” determine how much the company is worth. The auction process consists of three major phases – packaging, marketing, and closing. There is both an art and a science to conducting a successful auction.
- A broad auction follows a similar path as a narrow auction, but the list of strategic and financial buyers is much broader numbering into the hundreds. The major benefit of a broad auction is that it can identify potential buyers that the entrepreneur never knew existed. These potential buyers in certain circumstances may be willing to pay substantially more than the intrinsic value of the company operating as a standalone entity. In the case of majority recaps, broad auctions can surface a “value added” financial buyer that is an excellent fit and has the resources, expertise, and network to significantly grow the company. A broad auction can take six to twelve months to complete from start to finish and places a fair degree of stress on the entrepreneur and the management team. The benefit of a broad auction is that it can lead to an outstanding result.Both narrow and broad auctions require being able to successfully access the Private Capital Markets. As can be expected, financial and strategic buyers are looking for good companies with strong performance and a competitive advantage that will drive future growth. Companies don’t have to be perfect, but they do need to be “fixable” if there are blemishes. The challenge companies face is rising above other companies in their industry and getting on the radar screens of financial and strategic buyers.
- Exit Funding: In addition to negotiating a suitable purchase agreement, the fifth key component is “funding” the transaction. Transactions are funded through a combination of debt and equity. On the simple side, a transaction could be a combination of cash and a seller note. On the complex side, funding could be a combination of senior secured bank debt, senior debt, mezzanine debt (a hybrid of debt and equity), preferred stock, warrants, and common equity. The buyer is typically responsible for arranging how the transaction is funded, but the company is ultimately the source of making the funding work. An experienced transaction team is essential, especially when multiple mechanisms are used to fund the transaction.
What the entrepreneur does after the transaction is closed depends in large part on how the transaction is structured and the type of transaction that is executed (total sale, majority recap, minority recap). For a total sale, there will be a personal and family transition for the entrepreneur. For a person who spent a decade or two growing and running a business that at times may have been all consuming, shifting gears can have its challenges. Anticipating these challenges and making plans in advance is a prudent course to follow. In addition to personal and family transitions, overseeing the investment management of a seven or eight figure portfolio, estate planning, philanthropy, civic and community service, hobbies and special interests, and mentoring other entrepreneurs can provide a richness in life not measured just in dollars. Of course, the option always exists to start the process all over again by launching a new company.
It takes a lot of work, energy, and skill to plan and execute a successful exit. Unlocking the economic value of a company, while ensuring a smooth and orderly transition to a qualified buyer selected by the entrepreneur based on both corporate and personal objectives, is an event few people earn the privilege to perform.
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