[SPECIAL REPORT: M&A UPDATE] CASHING OUT

Did you know that only one of three businesses is able to successfully transition from the first generation to the second? And that far fewer, only 13 percent, transition to the third generation? While there are certainly success stories of family transition in pest control, the increasing odds are that your children or grandchildren will not step up to take over your business and that you will want liquidity even if they do so that your financial well being is not tied exclusively to the future success of the business.

You can start planning now to increase the probability of a successful succession, whether to your children or an outside buyer. Steps you take today to plan for your eventual exit will help you maximize your liquidity when you’re ready to cash in and leave your company poised for future success beyond your ownership and active involvement.

THREE OPTIONS FOR EXIT.
The three most common exit strategies for any privately held business — outside of family succession — are a third-party sale, a private equity recapitalization and formation of an employee stock ownership plan. Each of these three strategies will enable you, the business owner, to trade a portion (or all) of your interest for cash. In this article, we will briefly detail the differences between the strategies, so you can begin to determine which path might be the best for you, your company, your employees, your family and your customers. Understanding your end game options will help you drive your company to the best position for achieving maximum value when the time is right. We’ll also give you some steps to enhance the marketability of your business so that it is attractive to potential owners for reasons well beyond its book value.

STRATEGIC THIRD-PARTY SALE.
Perhaps the most widely known of the three options is an outright sale to a third party. Usually, a third-party sale means that you, as the business owner, will sell 100 percent of your ownership interest in exchange for cash.

This type of transaction is typically referred to as a sale to a “strategic buyer.” The buyer is strategic in the sense that he is typically already active in the industry and is looking to expand his business through acquisitions. Your company must fit the buyer’s acquisition profile, likely in terms of size, geographic footprint, customer base and business mix.

While there have been numerous strategic buyers in the pest management industry over the years, certainly the two most prolific are Orkin and Terminix. These buyers are looking for good companies run by good people. While the equipment, facilities or other assets that come with the deal are important, the pest control industry’s strategic buyers are focused on your reputation, your ability to deliver the highest level of service at a competitive yet profitable rate, and your valued and valuable clients.

While the third-party sale is perhaps the quickest and cleanest way to cash out, some business owners have reservations about this strategy as a solution. A strategic buyer will look to integrate your company into his, which could lead to some loss of duplicative staff. It also can mean a loss of the brand name and corporate identity that is such a part of the culture you have built. This can be a tough pill to swallow, yet might make the best sense for achieving your personal, financial and professional goals.

PRIVATE EQUITY RECAPITALIZATION.
For the owner seeking substantial liquidity, yet willing to continue to lead the business for several years, or for the owner looking for capital to grow the company, a private equity recapitalization might be best.

In a private equity recapitalization, an institutional investor, such as a private equity group (PEG), acquires an interest in the company, often with the agreement that the owner and his team will stay on to grow the business both organically as well as through acquisitions. In a recapitalization, the business owner receives substantial personal liquidity and diversification for the interests sold. Although a PEG typically acquires a controlling interest, this strategy allows the business owner to remain a significant shareholder and continue to be the driving force behind the company.

Unlike strategic buyers, PEG buyers often look to maintain the brands they acquire, realizing the value in brand recognition and the loyalty of the management, employees and clients. Therefore, post-transaction, the company likely will continue to operate under the same brand name. As financial buyers, PEGs do not want to be involved in the daily operations of the business, but rather are looking to contribute capital and other resources to help leverage the talents of the existing “best in class” team. The PEG’s goal will be to partner with the business owner to grow the company over a period of four to seven years, on average, and then sell it to generate a return to their investors. Most equity groups have well-defined strategies as to the type and size of companies they invest in, how they structure their deals and their investment time horizons.

This deal is often the best choice for an owner who wishes to get substantial liquidity off the table, yet keep their brand and their team to grow the business with continued upside and significantly lower personal risk. The best candidate companies for a private equity recapitalization will have a well thought-out plan in place to grow the business more aggressively. In a recapitalization, size matters and only larger companies will likely attract a PEG. Usually, PEG buyers are actively focused on investing in new platform companies in specific markets as well as adding on with acquisitions in their existing markets.

EMPLOYEE STOCK OWNERSHIP PLAN.
While perhaps the most maligned and misunderstood of the three, the employee stock ownership plan (ESOP) might be the only choice for some companies. It also may be the best choice for those seeking to retain and reward employees while reaping the significant tax advantages the ESOP provides.

An ESOP is another liquidity or exit strategy that allows the selling shareholder to get full, fair market value for any interest in the business that is sold, yet maintain operational control. The unique aspect of an ESOP strategy is the ability to reward employees with real ownership in the company. Further, if properly designed and implemented, an ESOP can create exceptional tax benefits for both the selling shareholder and the company. Considering the projected rise in capital gain rates in 2013, an ESOP is a timely choice for maximizing value.

The ESOP strategy is similar to the others in that the starting point is negotiating the value of the company. Once value has been established, then the company must secure financing for a loan to the ESOP. The ESOP will use the funds to purchase the business owner’s stock, which is then allocated among employee accounts in the ESOP. Over time, as the company generates profits, the loan is paid down and the employees’ ESOP stock accounts are filled with allocations of shares in the company. The ESOP can therefore serve as a qualified retirement plan for company employees, allowing them to retire with significant stock value in their ESOP account without them ever having to invest a penny of their own money.

While the tax benefits of the ESOP vary depending on a host of factors, including what type of entity you have chosen for your company, they can be substantial. With guidance from excellent advisors, this strategy can result in tax savings for the company and for the selling shareholders, helping them to avoid paying capital gain taxes on the value received from the sale of their stock to the ESOP and potentially being able to deduct the full principal and interest on the purchase.

The tax benefits and the prospect of sharing real ownership with key employees are often the driving factors in the creation of an ESOP. However, the ESOP may be the only real alternative for liquidity if a strategic or PEG buyer does not materialize with a value that represents a full, fair market return to the shareholders. Several of the industry’s 25 largest, privately held firms throughout the past 20 years have successfully implemented ESOPs as a solution for owner transition.

THE END GAME IN MIND.
As a starting point for enhancing marketability, it is important to remember that the goal of any potential buyer will be the same as yours — to grow your company’s revenues and profits by increasing the number and quality of accounts, increasing efficiency of operations and decreasing unnecessary overhead. Doing so will require a nimble team of professionals committed to the company’s growth.

The ideal time to sell your company is while its prospects for continued growth and profitability are still on the rise. While you continue your goals of increased revenue and profits, positioning your company for sale requires an additional focus on shoring up your company’s infrastructure, putting an effective organizational chart to work, recruiting a best-in-class team of employees and advisors, and keeping accurate, organized and professional records. Here are some tips for transforming your business into one that could generate a bidding war among buyers.

RECURRING REVENUE.
In order to get maximum value for your firm, you should ideally sell when the business is able to demonstrate both historical and projected growth.

If your profits are flat to declining and you are able to attract buyers, they will likely be the variety who want to buy it cheap. Remember that your revenue is irrelevant if you are not making any money. Growth and profitability drive value. Further, in the pest control industry, value is especially driven by ongoing and recurring revenues. While one-time, project-oriented jobs might instantly boost sales and profits, their cyclical nature, as well as issues of retention, make this segment of business less valuable from the buyer’s perspective. It is always better to have strong recurring profits in order to get the highest valuation.

BENCH STRENGTH.
Potential buyers may scrutinize your team as much as they examine you, the owner. They will always think, OK, if I write this guy a big fat check and he goes off to Belize, who will run this business after closing? While the buyer might technically be buying the assets of the business, they will find the company’s real value and growth potential in the people — you, your employees and your client base. In order to push the value of your company, you must build “bench strength” by incorporating key responsible players on your team that will outlast your career with the company.

Simply put, sales grow from relationships. If all your company’s sales are built on the founder’s relationships, potential buyers will question their ability to generate comparable sales when the founder exits. You can boost the marketability of your company by institutionalizing your business development efforts and assigning sales responsibilities to other leaders within the company.

Buyers love to see a team of capable employees that can shoulder significant growth. However, we often see flat organizational charts, where everyone seems to report to the owner. This is often clear from our very first meeting with a client — the number of times the meeting is interrupted by employees seeking guidance on sales, estimating or field-oriented issues that can and should be solved by someone else, is a great barometer of how efficiently the company might run when the owner has moved on.

The transition to new ownership is less stressful on employees accustomed to effective delegation of operational responsibility. Strive to create a scalable organizational structure so that your company can run without your constant input.

INFRASTRUCTURE.
While a bookkeeper and QuickBooks can get you going and last for a while, they likely won’t support your company through the sort of growth you and your buyer are expecting. Make it your goal to make your information and data work for you. Find and implement resources that your team can access with ease to create and effectuate your growth plans.

In order to grow you must employ systems, procedures and technology that will allow your company to flourish. A buyer will be attracted by smooth-running and easy to use systems. Many owners think they can skimp on this since the buyer will just plug them into their systems in the end. While that may eventually happen, buyers will discount your value if you have not built an organization of real quality.

Advisors. While you certainly do not need to go hire the most expensive accountants, attorneys and insurance advisors in your city, it is essential that you back your success with the advice of professionals who can provide full service to your growing company — today and tomorrow.

Many owners stick with their original advisors and end up outgrowing their ability to get the advice they need. While the practice of being loyal is an admirable one, you should not sell your company short with advisors who can’t continue to bring value and expertise to you. There is tremendous benefit to building a team of advisors that is skilled and experienced enough to see your company through a major sale transaction.

Further, advisors can add value to your company pre-sale by readying your corporate structure and financial records for a smooth closing. For example, an excellent attorney can help advise you on the benefits of registering as an S corporation or a limited liability company rather than a C corporation, prior to marketing your company for sale. While there are a multitude of considerations regarding corporate form, in general, C corporations introduce inefficiencies to a sale process, whereas structuring a deal for an S corporation or an LLC is far simpler. A capable accountant will help you get your financials shipshape — drastically reducing the time required to prepare your company to market. Quality corporate information and financials are absolutely key to surviving the due diligence process with your valuation intact. While you don’t necessarily need audited statements to get a deal done, maximizing value is certainly easier when a reputable third-party provider has at least reviewed your numbers and blessed them as materially correct and in compliance with generally accepted accounting principles.

An investment banker or M&A advisor can help you understand the specific components of valuation, marketability, timing of the deal (yours and the markets), and how to position your company to achieve its highest and best value. They can also work with you to help organize your results and slice and dice them at a buyer’s request.

A buyer might ask you to list your top 25 clients by revenue for the last three years, demonstrate gross and net profitability by customer, service line or branch, and demonstrate client retention over a historical period. Are you prepared to do so? Well-suited advisors can address issues early and get you prepared, removing obstacles to the sale of your company.

PERKS.
You own a business. And, if you’re like most business owners, you probably enjoy the perks of being in charge — one of which includes choosing how and when to compensate yourself for all your hard work. While it is not our job to opine on exactly how business owners choose to do this, you need to know that your compensation and the perks you provide to other shareholders or family members from the company’s coffers will be scrutinized in great detail.

While we can convince a buyer to make adjustments to the value of his or her company for these perks, and thus normalize the company’s true earnings, there are limits. If the amounts are considered egregious, you will raise concerns and doubt in the eyes of a buyer. Significant personal expenses often make a buyer wonder whether there are more being hidden and how they will affect the value of the company post-sale. While you should enjoy the benefits of owning a business and not pay more taxes than you need, pushing the envelope too far will likely hurt your company’s marketability.

FINAL THOUGHTS.
It is never too early to begin looking forward to your exit and planning to make it as easy and as profitable as possible. Keeping an eye on marketability, as well as value, is essential. With these goals in mind and a working understanding of the options that exist in the market, you will be well equipped to transition your company when the right time arrives.

CCG Advisors (www.ccgadv.com) is an Atlanta-based merger and acquisition firm specializing in advising owners of privately held companies on business valuation, strategic growth planning, capital alternatives and exit strategies. CCG represents business owners nationally and across all lines of industry in the sale, recapitalization or ESOP of their companies.

Brian D. Corbett is the managing partner of CCG Advisors. He can be reached via e-mail at bcorbett@giemedia.com.