A well-crafted succession plan is a vital tool for businesses today, and not just for those with an imminent transition at the top. Any business with a potential change in ownership coming sometime in the next three to five years should start the process now of building a succession plan that meets the needs of its owner(s).
With increasing regularity, businesses are choosing external paths towards succession planning, rather than turning things over to either family members or employees. Many times family members are not interested in taking control or the parent/grandparent does not feel comfortable leaving it to them, and the idea of other employees assuming management may not be viable. When looking externally, the best transition route may be with a private equity firm.
The gradual economic recovery since the 2008/2009 economic crash has contributed to this trend. Bank lending remains difficult to attain, but private equity firms have cash available to invest. This cash flow often makes this exit strategy very attractive.
In addition, private equity firms must put this cash to work in investments or risk losing it. Therefore, multiples being paid by private equity firms have generally been increasing.
To make this work, it all begins with planning. There are many reasons for a business owner to begin the transition process and create a succession plan before it is time to sell. The age and/or health of the owner are certainly factors, as is the desire to move on to his/her next phase of life, perhaps retirement or a new business challenge. Once an owner decides to choose the private equity path, planning should begin immediately–the sooner the better.
A succession process starts with what financial planners call the pre-diligence phase, a critical time to establish the current value of the business and take steps to move it towards a maximized exit value. The value is most often determined through a multiple of Earnings Before Interest Taxes Depreciation and Amortization (EBITDA). It is common in negotiations for potential buyers to attempt to drive the EBITDA number down; naturally a seller will want to prevent that.
This is where pre-diligence is a strong safeguard. Owners should examine their business through the eyes of potential buyers in order to gauge strengths and weaknesses in an effort to maximize the company’s value upon sale and to prevent downward adjustments proposed by the buyer. It is also essential to set a goal for the business to determine what the owner needs or wants from the business financially. Most likely this is the major source of income and will not easily be replaced once the sale has occurred, and they will need to last a lifetime. Identifying this value gives an owner a roadmap on the steps needed (such as increasing sales or upgrading technology) to achieve desired valuation before private equity buyers are sought.
Other considerations to be addressed during this pre-diligence period include whether or not the employee base (or a portion of it) will be retained after the transition and how long the owner plans to stay. Often a period of 12 to 18 months is desired for an owner to remain on while the transition takes place.
Once pre-diligence concludes, employee considerations are set and the terms of the succession plan are established, an owner should talk to a business broker to identify the right private equity firms to approach as potential buyers. The broker will narrow the list to those firms that best meet the seller’s desires and then solicit bids. After a bid is chosen, negotiations begin, conditions of sale are set (regarding employees, ownership transition and other considerations) and the acquiring firm begins its diligence process, which can take anywhere from a few weeks to over six months.
This is why a proper succession plan/pre-diligence pays dividends. A clean and quick diligence process will often lead to a completed transaction with minimal to no adjustments, while a poorly executed plan (or none at all) can mean large downward adjustments on the sales price or even a broken deal. It’s true that time and legwork are needed to get a successful succession plan in place, but this investment far outweighs the risk of not having a plan. Unforeseen issues, such as the sudden illness or even death of key management people, can put unprepared businesses in immediate danger and leave them open to the predatory advances of outside interests seeking to either take over or liquidate. Failure to plan can also place a business behind the curve in terms of peak times or economic downturns, which could greatly damage the overall value.
Once again, preparation is essential for succession planning. For owners who have spent their lives building a thriving business, a well-executed succession plan can provide the peace of mind in knowing there will be continued success for years to come.
Steven A. Gagnon, CPA, is a principal with BlumShapiro.
This article first appeared in the Fall 2014 issue of Massachusetts Family Business, the magazine of the Massachusetts Family Business Association.