Selling your business can be a difficult decision, but for owners who don’t have an obvious successor, it can be the best option to preserve their legacy. In this article, an excerpt from Mergers and Acquisitions for Distributors: Expert Advice for Buyers and Sellers, available from NAW, Evergreen Consulting’s Brent Grover provides expert insight into this consideration.
Selling as an Exit Strategy
Most of the entrepreneurs who founded distributors didn’t have an exit strategy in mind when they launched their companies. Many started out their careers working for another distributor or perhaps for a supplier, and they had the urge to own their own business. Some founders designed their companies around the kitchen table just because they were unemployed and no one would give them a job. These early stage businesses were all about survival. The new owner didn’t have an endgame strategy in mind when the company was launched.
As their companies became successful, much of the ownership succession planning that first-stage owner-managers did involve the use of life insurance to ease the ownership transition from one generation to the next. Ownership succession within the family was virtually a given. In the less affluent, less educated, and less mobile society of yesteryear, going into the family business was an easy choice for the next generation.
Planning became more complex for second-stage businesses due to the advent of income and estate taxes. The life insurance industry sold policies to distributor owners not only to provide income to widows but also to pay estate taxes. Many businesses also bought policies as key-man insurance or to fund buyouts between partners. More and more distributors, initially established as sole proprietorships or partnerships, chose to become corporations to take advantage of tax-deferred retirement plans (profit sharing and sometimes pension plans) and the LIFO inventory method.
As distributors prospered and tax laws changed, many companies then became pass-through entities (S corporations and later LLCs) for income tax reasons. Estate and gift tax planning gave rise to sophisticated tools such as family limited partnerships, defective grantor trusts, dynasty trusts, and generation-skipping trusts. Wealthy distributors began using their companies to make large gifts to charity. Life insurance agents sold split-dollar policies to business owners to minimize taxes.
When the time comes to sell these businesses, the legacy of the planning that was done (or not) has strong implications for the timing and structure of transactions. As Joe Pease explains, there can be two levels of income tax paid if the company sells its assets and then distributes the proceeds to the shareholders of a corporation. Companies electing subchapter S status might need to wait years to realize the full benefit of tax avoidance. Assuming that the life insurance policies purchased over the years were not allowed to lapse, many distributors have very valuable life insurance policies on their books.
Much business continuity planning was intended to provide cash in case of an unpredictable event such as death of an owner. The goal of estate tax planning was to minimize the potentially pernicious effect of taxes. Without planning and adequate life insurance, the confiscatory nature of estate taxes was a direct threat on the ability of the family to avoid a distressed sale of their distribution business.
Thinking Beyond Family Succession
It’s a huge jump from planning business ownership succession within the family to exploring all the other possible options. Considering a potential sale to nonfamily owners broadens the scope dramatically to include options such as
- sale of all or part of the business to an employee or employees (or to an ESOP)
- taking in an outside party as an equity partner
- sale of the entire business to a strategic or financial buyer.
Some of the considerations about selling a business are highly personal: advancing age, health concerns, loss of interest in working in the business, lack of an interested and qualified successor, or a group of prospective family owners who don’t have good chemistry with one another.
Owners often decide to sell their companies because the business isn’t doing well and they either don’t know how to turn things around or they don’t have the capital or management team needed to do so. These situations are complicated by the time pressures owners are under if they think the value of their company is declining.
On a positive note, some owners believe the performance and value of their highly successful company is peaking. Perhaps they want to sell to reap the financial rewards of years of hard work.
Seize the Day
There is a perfect time to start planning an exit strategy for a distribution business. Ideally, the owner (or leader of the ownership group) has a vision for the long-term future of the business. The time horizon has to do with what the leader wants the company to look like when his or her career is finished. Coming to grips with that vision and then articulating it are part of an effective strategic planning process.
Even if the leader does not envision a sale of the business during or at the end of his or her career, contingency planning should include a scenario in which a sale becomes the best option. For example, an unsolicited offer might be made by a qualified prospective buyer. Other drivers include drastically changed industry conditions, new competitors, or substitute products coming onto the market.
Even if the distributor owner loses control over the timing of a sale, he or she must never lose control of the companies’ preparation for that eventuality. Therefore, the perfect time to start planning the exit strategy is now.
The board should never be forced to turn down an excellent offer because management isn’t prepared to sell. I’m not referring to situations in which the board feels the company will be worth much more in the future. Examples of lack of preparation include unfortunate circumstances such as accounting records that are in poor shape, messy receivables, out-of-control inventory, dysfunctional ERP system, low morale, high turnover and poor housekeeping in company facilities.
Owning and running a distribution company that isn’t ready for sale is far from being a pleasure. However, it can be frustrating even if the business is successful in spite of itself – which does happen.
Owners of successful distribution businesses should expect and be prepared for inquiries from prospective buyers. They arrive in different forms – letters, phone calls and feelers from third parties. Some inquiries might be from parties fishing for leads even to the point of misrepresenting themselves, but a little research will reveal if the contact is from a legitimate source. The CEO has a duty to get as much information as possible and to report serious inquiries to the board. The CEO, however, should not give out any information to prospective buyers. I’m surprised by how some owners, caught at a weak moment, provide potentially valuable competitive information to strangers. If there is interest in advancing the discussions, any information sharing must be done only under an NDA approved by the company’s attorneys.
Monitoring the Value of the Business
If the business is clearly not for sale, is it useful for ownership to keep track of the market value of the company? The answer is yes.
Distributors with ESOPs, for example, are required to get annual appraisals of their shares. In another example, top management team members whose compensation depends on company value (assuming they own stock, stock options or phantom stock) want to know what their equity interest is worth.
Strategically minded managers and responsible board members want to check the market value of the company periodically. In most of these cases, a full-blown appraisal is not necessary; however, appraisals are required for ESOP companies, stock redemptions, and other transactions involving the company’s stock.
Brent Grover is the founding partner of Evergreen Consulting LLC, which advises distributors on profit optimization, strategic pricing and customer profitability. He has also served as CEO and co-owner of a paper, packaging and janitorial supplies distributor.
Order Mergers and Acquisitions for Distributors: Expert Advice for Buyers and Sellers at http://www.naw.org/mergers.