Future Action

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learning objectives After studying this chapter, you will be able to: LO13- 1

Explain the need for developing an exit or harvest plan and ideal timing for that plan.

LO13- 2

Outline the steps for selling a business.

LO13- 3

Discuss the concept of turnaround and business in decline.

LO13- Recognize the implications and issues involved in closing a business.

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4

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Exit/Harvest/Turnaround

TEALUXE

Bruce Fernie opened Tealuxe in 1996 in Harvard Square, Cambridge, Massachusetts, to bring “Tea for All” to the masses in the same way that Starbucks brought specialty coffee to the world. Carrying more than 100 types of tea, he opened storefronts in trendy, urban, college campus areas. Tea, however, is not the same business as coffee is in the United States. Although tea is the second most popular beverage in the world after water, it is not very popular as a daily drink in the United States. Starbucks provided a premium product that a majority of Americans already drank on a daily basis: coffee. However, it was not clear that there was a demand for a wide range of teas beyond those Starbucks already offered.

Tealuxe stores were attractive and nicely placed, and some began doing a significant business. However, Bruce Fernie had no interest in actively managing the storefronts, or for that matter, the operational side of the business. He considered himself a big-vision person and did not enjoy the daily operations. With no consistency in operational management, the company made numerous missteps. For example, he once opened a storefront in the New York City Atrium at a rental rate that all but guaranteed failure. He closed that operation within six months.

Having to repeatedly put expansion plans on hold kept distracting the management from the business of running the stores. In July 2001, Tealuxe cut back to four stores from seven and filed for Chapter 11 bankruptcy. “Chairman and Co-Founder Bruce Fernie, who himself expressed no interest in running the business day to day, blames the management that was hired to implement his ideas and the abysmal real estate deals and store-level control they implemented.”

A private equity firm purchased Tealuxe out of bankruptcy and attempted to grow the business. In 2010 the Tealuxe store in Cambridge was named one of the top five tea houses in New England. Despite positive reviews as of 2014, the company has been cut back to just two store locations. The company is looking to franchise as a means to grow. The chain’s Internet business has become much more important to the firm, a fact that is highlighted on the firm’s Web page (www.tealuxe.com/).

Businesses fail for many reasons, but for an entrepreneurial business, a hands-on approach and a complete understanding of the competitive advantage model for the business is essential to survival.

Questions 1. Given that Starbucks has purchased Teavana and is planning to grow that effort, what do you see as the future for

Tealuxe? 2. Why has Tealuxe not grown beyond two stores despite the investment of capital? 3. What would you do to turn around the business?

Sources: J. Sloane, “Bruce Fernie Wants to Do for Tea What Howard Schultz Did for Coffee . . . Is He Kidding?” Fortune Small Business 11, no. 3 (April 2001); J. Sloane, “Tealuxe Puts Its Plans on Ice,” Fortune Small Business 11, no. 8 (October 2001); K.

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Municheillo, “Best 5 New England Teahouses,” Yankee Magazine, March/April 2010, www.yankeemagazine.com/article/travel/teahouses-me-ma-ct-ri; Tealuxe Web page, http://www.tealuxe.com/.

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Eventually there will come a time when the founder(s) needs to, or wants to, exit business. This decision may be based on a variety of factors. One may be that the business has done very well and the founder(s) has decided to cash out of the venture. On paper the founder(s) may appear to be very wealthy, but if all of the assets are in the business, then the individual’s assets are not liquid and are subject to rapid changes in wealth as the value of the business changes. Selling the business turns some of the hard earned sweat equity into cash. The ability to turn some or all of the business value into cash at some point allows the business owners a flexibility in their choice of actions and businesses as they go forward.

Alternatively, it may be that things have not gone well and the founder(s) needs to either turn the venture around or close down the business. A wide set of issues must be addressed in all of these cases, including such issues as a plan for establishing the value of the business, attracting buyers, negotiating a sale, meeting all of the legal requirements for the sale, consummating the deal, and paying off the investors. These issues can become even more complex if you have to look at turning a business around that has started badly. While difficult, the ability to turn a business around is a valuable skill. This chapter will explore these areas.

LO13-1 Explain the need for developing an exit or harvest plan and ideal timing for that plan.

Need for Developing an Exit or Harvest Plan and Ideal Timing for That Plan The entrepreneurs benefit from considering several dimensions of what is required to sell the business, both at the founding and when they begin the selling process.

Why Consider Exit or Harvest Now? It may appear odd to consider the topic of exit and harvest while you are only beginning the process of getting the new business up and running. However, early stage entrepreneurs must consider a well-defined exit plan before personality clashes arise. A business is an investment of both time and money. In addition, developing a practical exit plan can provide some peace of mind to the family and the investors so they know what to expect if things do not go as planned. The key starting point for any decision to exit or harvest the firm is establishing the valuation of the firm. Developing an accurate valuation as the firm begins to have cash flow helps:

1. Provide insight for the founders as to the amount of future capital and labor that they should invest in the effort. 2. The business obtain loans (either direct or working capital) by demonstrating the value of the firm to potential creditors. 3. Convince outside equity investors of the potential long-term returns associated with the harvesting of the business. 4. The owners field potential offers to buy out the business (a relatively common occurrence in the life of a business). 5. Benchmark the growth of the firm by establishing a true starting point.

Why Consider Exit or Harvest Later? Having laid at least some initial groundwork will help the entrepreneurs if they later decide to exit the business. As discussed in Chapter 2, the entrepreneur must determine what he wants to accomplish in the business.

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Although the founders of Friends’ had never even considered selling their business, they were caught completely off guard when a hospital approached them about buying the entire operation. In the surprise call, the hospital president let Betty and Joan know that he would buy them outright now for $400,000, and furthermore, he wanted the founders to stay on with the business. The hospital would provide the founders a guaranteed two-year management contract at $90,000 per year per person, plus 15 percent of the yearly profits during those two years. The hospital president presented this deal to the founders of Friends’ claiming that the total package was worth approximately $800,000 (assuming that profits grew respectably), which he claimed was the value of the business right now. The resulting conversation among the two partners focused on three critical issues. First, should they even consider selling the business at this point? Second, if they did consider selling, what would be a reasonable price for the business? Third, what were their personal long-term goals, and did this offer get them closer to those goals?

To consider these questions, Betty and Joan had to figure out how much the business was worth. For advice, they approached a friend who had worked in mergers and acquisitions (M&As) as a consultant to manufacturers, and he suggested that the real value of a business was simply the market value of the assets of the firm plus a premium (which he referred to as goodwill), which represented the future value of the firm. He suggested that many M&A deals pay a 20 percent premium above the market value of an established public business. Using this calculation, the founders estimated that the business was worth $180,000 ($150,000 in equity capital and equipment plus 20 percent). However, this number did not seem to account for the potential of the business, and in any case, was substantially less than what the hospital had offered.

The founders contacted two members of their board of advisors and asked for their advice. They quickly discounted the friend’s advice regarding M&As as not applicable to a services business. They told the founders to forecast net cash flow for the next five years (five years was chosen as a reasonable return period) and then discount that number back to the present time using a reasonable discount rate for risky newer ventures (say, 20 percent). So, the founders estimated net cash flow for the next five years as follows: Year 1 $94,296 Year 2 $15,075 Year 3 $102,305 Year 4 $132,066 Year 5 $167,009 5-Year Total Earnings $322,159 Discount Rate @ 20% 2.488 322,159/2.488 = $129,485

QUESTIONS 1. What do you think is a fair value for this firm? 2. Assuming that a fair value can be calculated, should the founders sell the firm at this point? Why or why not? 3. What does your answer to question 2 say about your risk propensity?

If the business is very successful but is no longer interesting or enjoyable, it is probably a good time to exit. A business takes too much time and personal commitment to be something that is not enjoyable. Similarly, there may be other opportunities available. The entrepreneur may not have time to run the existing business and pursue these new opportunities at the same time, so it becomes necessary to exit the first business. Alternatively, the founder may sense that whereas the business is strong now, the future does not hold the same potential for similar success, so it might be a good time to exit.

One example is an entrepreneur we knew who set up a number of sports shoe stores. Several years after founding, the owner began to realize that there were major chains entering the market, which was leading to market saturation in his area. He would have to completely reset the strategy of the business in order to compete in the future. This individual decided

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to harvest the venture and sell it to someone else. He reaped the value of the business that he had grown without having to go through the painful process of resetting the strategic position of the firm.

LO13-2 Outline the steps for selling a business.

Steps for Selling a Business When a business owner decides to sell or harvest the business, there is a series of steps that need to occur. The first is to develop some sense of the true value of the business. The second is to prepare the business to be sold. The last step is the negotiation and actual selling of the business.

Valuation There are several standard valuation models and rules of thumb for established, publicly traded businesses. For example, public companies have an established market capitalization that is technically the value of the business as it exists at the present time. Following the standard on Wall Street, this market capitalization already accounts for future earnings and all future prospects of the business that are known today. If you wished to acquire one of these organizations, the general assumption would be that the market capitalization is the floor from which all negotiations begin. Calculating the premium that will be offered above the market capitalization is more a matter of art than one of science.* Issues such as how much cash will be paid versus stock transferred and the future investment in the newly combined organization are a matter of negotiation, not to mention the overwhelming concern regarding what will happen to the executives of the acquired firm. These issues are substantially different when we consider the valuation and acquisition of a privately held venture.

Virtually all new businesses are private firms that do not report their earnings to the public. In addition, new businesses often adjust their annual company “earnings” with the payment of large year-end bonuses to the founders in order to limit the profit and therefore the taxes on the business. The new business may also have creative company perquisites (“perks”) for the owners to minimize the tax owed by the organization. The owners of a new business may also have other individual personal expenses paid for by the firm. The result is that the firm pays fewer taxes, but the firm also may appear to be worth less than it is really worth to the entrepreneur.

perquisites Benefits paid for by the company. Examples include vacations, vehicles, loans, gifts, financial contributions to retirement plans, and so on.

For example, a firm such as Friends’ Home Health that is owned by two individuals allows the founders to use “profits” for the benefit of the firm as well as themselves in a perfectly legal and ethical manner. If sales were particularly good in one year, the founders may decide to provide luxury cars as a perk for themselves. This expense dramatically reduces the “profit” of the venture, whereas the reality is that the business is quite profitable. Similar expenses also occur in public companies; however, they are required to disclose such items in an audited annual report, whereas a new business venture rarely goes to the expense of having audited financial records. Thus, it should be clear that different methods of valuation are needed when considering the purchase of a private company.

There are a large number of unique systems used for the valuation of a private business. Most accounting groups and many private companies

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provide business valuation services. We would suggest that you work with these organizations when you are really ready to sell the business. They will use commonly accepted practices to refine the value of the ongoing business. However, in general, we encourage the entrepreneur to use only a few of the most common methods to get a rough estimate of the value of the business as the business begins and grows. Valuing a business is as much art as it is science. Ultimately, the true “value” of the business is the amount of money that a willing seller and a willing buyer agree upon for the sale of the business. Thus, you want to be well prepared for the range of prices that may be offered and understand why you might agree or not agree with those prices. An investor, lender, or potential purchaser may take issue with several of the assumptions in your projections, or might want to reduce the numbers more severely than the founders believe is realistic. To maximize the selling price of the firm, the founders must intimately understand the numbers to be able to discuss such issues intelligently with those individuals. These methods include (1) discounted future net cash flow; (2) price/earnings valuation; (3) asset-based valuation; (4) capitalization of earnings valuation; and (5) market estimation valuation. __________ *There are a number of other quick methods for calculating a purchase price, including a multiple of sales, discounted future earnings, discounted projected free cash flow, and so on. We provide all of this by way of comparison.

Discounted Future Net Cash Flow. By far the most widely accepted method of valuation, and the most insightful, involves some form of discounting the estimated future net cash flows of the business. As you might recall from Chapter 6, cash flow tracks the actual cash inflows and outflows of the business. For estimation purposes, a potential buyer can subtract any perks that have affected the net cash position of the venture. The detail available in a well- designed cash flow statement and the understanding that it is not profit, but free cash flow that is the key to entrepreneurial success makes this the ideal document to use in the valuation of a business.

The cash flow method of valuation requires that the net cash flow of the business be projected for some period of time into the future. Our experience has suggested that estimating cash flows five years into the future and adding a salvage value for the firm is a good ballpark floor valuation for a business. For an Internet business, the cash flow method works very well although there is typically no salvage value for any of the assets since even used computers normally have minimal value. The information for this example appears in Figure 13.1.

In this example, the net cash flow for each year is as follows: Year 1 $101,885 Year 2 $30,575 Year 3 $143,725 Year 4 $161,000 Year 5 $446,100 Those most interested in a good estimation of firm value (potential buyers, lenders, equity investors, and founders) will

recognize that these numbers are simply estimates that are based on a set of assumptions. To understand and accept the cash flow predictions, it is important that each interested party accept the underlying assumptions. Therefore, a critical addition to any business plan, and certainly a necessity for any valuation analysis, is a complete set of assumptions used by the founders. An example from a group of entrepreneurs that were proposing a specialty transport company appears in Figure 13.2 and Figure 13.3. This company would transport people to sports events related to local colleges. The business would start focused on a single school and ultimately expand to other schools. The plan was to sell alcohol and limited food on the bus. We will use this firm as an example to evaluate the different valuations that the firm could expect.

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Figure 13.1 Example Cash Flow Statement

Discounting the Cash Flow. The example above illustrates that to understand a cash flow statement, an entrepreneur needs to have an in-depth knowledge of the assumptions that went into the statement. Given the nature of predictions and assumptions in general, there is a need for these values to be discounted by some rate that not only represents the return expected by an investor, but also accounts for the riskiness of the venture. We have seen discount rates range from a ridiculously low 10 percent to an almost absurd 90 percent. However, a rule of thumb for new businesses being operated by owner-managers is to use 30 percent as a discount factor. This should not only account for a generous annualized rate of return but also build in a reasonable factor for risk. While we are in favor of simplicity in these calculations, we recognize that some interested parties prefer to separate return from risk. There are a variety of sophisticated financial models available to those who wish to be more precise in their analysis.

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Cash Flow categories will vary with the type of business being analyzed.

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Figure 13.2 General Cash Flow Assumptions for Specialty Bus Company

Using this rule of thumb, the entrepreneur should take the net cash flow figure generated for each year and discount that cash flow back to today’s dollars. The discount rate remains the same, while the factor increases as you move farther away from today. Thus, in year 2, the discount rate is squared (1.3 * 1.3), in year 3 it is cubed (1.3 * 1.3 * 1.3), and so on. To illustrate with our previous example, we calculate the present value of the net cash flow below.

Illustration of Present Value of the Net Cash Flow. Using the information in Figure 13.1 and assuming a 30 percent discount rate, we can calculate the present value of the net cash flows as follows:

Without accounting for the sale price of the business, this calculation would suggest that the current value of the business is approximately $180,000.

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Figure 13.3 Example of Specific Cash Flow Assumptions

Price/Earnings Valuation. Another method of estimating the value of a business is to use the industry price/earnings (P/E) ratio. This is a relatively straightforward system that uses the industry in which the start-up operates. The founder should locate the P/E ratio for public companies in the same industry via the many sources of this information (the Internet, The Wall Street Journal, the library, etc.). That average should be multiplied by the net cash flow for year 5 and discounted back as a potential sales price in year 6 of the venture. Therefore, for our specialty bus company we employ 1 + the discount rate raised to the 6th power. In our example that would be 1.36 (4.826).

price/earnings (P/E) ratio A value derived from public companies that divides the current earnings per share into the price per share.

Illustration of P/E Ratio Valuation. This example illustrates how to calculate your P/E ratio valuation:

P/E for Industry 10 (obtained from industry sources) Net Cash Flow for Year 5 $446,100 Discount Rate 30% Sale/Residual Value 446,100 * 10 = $4,460,000

4,460,000/1.36 = Discounted Sales Price 4,460,000/4.826 = $ 924,005

Using these calculations, we would suggest that the value of the firm today would be the addition of the present value of the future cash flows

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plus the discounted sales price of the firm. For this example, that would be the following:

There are two other relatively popular methods for valuing a business: asset-based valuation and earnings valuation.

Asset-Based Valuation. Asset valuation involves accounting for all of the hard assets of the organization: buildings (if owned), equipment (if owned), furniture, cash, and marketable securities held in the name of the company, as well as (in most cases) the value of any signed and executable contracts. Once all of the assets of the organization are tallied, the value of the business is typically calculated by taking that total number and adding an acquisition, or goodwill, value to it. This acquisition/goodwill value is determined by examining similar companies that have been acquired, or more often by simply looking at the percentage premium being offered in general on all new public acquisitions. If the business were performing poorly, there would be virtually no goodwill value. Asset valuation is typically the lowest business valuation number that you will calculate, unless you are an asset-intensive business. This valuation method works best for firms with hard assets and not an Internet business.

asset valuation

A method of business valuation that simply totals all of the hard assets of the organization and adds in a goodwill value.

Illustration of Asset Valuation. Following is an illustration of asset valuation for a restaurant rather than our bus company since it allows a richer set of assets. The bus company leased its buses, so there were very limited assets. In a case such as that for the bus company, asset valuation method is of limited use:

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In this particular instance, a quick analysis of the industry revealed that an average asset-acquisition premium for this particular industry was running at approximately 4.3 times assets. Each industry will be unique and the appropriate multiple will vary over time with changing market conditions and industry M&A activity. Therefore, the business as it currently stands (via this method) would be worth approximately $860,000. This method tends to depress the true future value of a growing business, so some investors and lenders will factor in a growth premium to “bulk up” the total valuation. “Art” intrudes once again.

capitalization of earnings valuation A method of valuation achieved by taking the earnings (net profit) of the organization; subtracting or adding any unusual items that the lender or investor feels are not customary, normal, or usual items; and dividing that figure by a capitalization rate.

Capitalization of Earnings Valuation. Very similar to asset valuation, capitalization of earnings valuation is performed by taking the earnings (net profit) of the organization; subtracting or adding any unusual items that the lender or investor believes are not customary, normal, or usual items; and dividing that figure by a capitalization rate. The capitalization rate is determined (rather loosely) by the nature of business, including longevity, business risk, consistency of earning, quality of management, and general economic conditions. The capitalization rate is generally an agreed upon number rather than something that can be “looked up.”

Illustration of Capitalization of Earnings Valuation. This illustrates capitalization of earnings valuation using our example of a specialty bus firm:

Using this system involves much more than simply accepting a final net profit figure. As was stated in Chapter 6, the net profit of a new business is an easily manipulated figure that is wholly dependent on the needs and desires of the founders. Therefore, lenders and investors adjust this figure to account for the individual actions of the founders. Would-be buyers readjust the net profit of the company to account for these nuances of a new business and then apply a capitalization rate that is a combination of the buyers’ risk propensity and the current situation in the business acquisition marketplace.

market estimation A method of business valuation that involves taking the earnings of the business and multiplying that figure by the market premium of companies in its industry.

Market Estimation Valuation. A valuation via market estimation is by far the simplest of the techniques. Fundamentally, it involves taking the earnings (or projected earnings) of the business and multiplying that figure by the market premium of companies in their industry. A popular method is to take the EBITDA (earnings before interest, taxes, depreciation, and amortization), reworking the figure based on an analysis of the cash flow statement, and multiplying the remaining figure by a market multiple. An examination of the NASDAQ or NYSE provides a group of companies in virtually every industry classification. Taking the group as a whole or attempting to find companies that are similar to your business yields an estimated market premium, also called an industry multiple, that can be used to calculate the value of the business. Once again, lenders and investors will attempt to adjust the earnings of the organization to reflect a more balanced picture.

Market Estimation Illustration. The following illustrates market estimation valuation using our sample specialty bus firm:

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Valuation Overview. As can be seen, there are wide variations in the potential valuations of this business, from several hundred thousand dollars to one and a half million dollars. Every company has unique features that provide it with some type of competitive advantage. In Chapter 5, we developed a strong argument for the development of a sustainable competitive advantage that enabled the new business to gain true economic rents relative to the competition. These “art” characteristics of an organization are important considerations in the valuation of a business and should be part of the equation when determining the true value of your business.

EXERCISE 1 1. Using your projected cash flow statement, develop a business valuation for your proposed company. This will mean forecasting cash

flow five years into the future. 2. Use your annual net cash flow as an estimate of earnings. Use the earnings valuation method and the market valuation method to

estimate the value of your organization 5 years from now. Assume that the P/E for your industry is 7 and the acquisition premium is (P/E ratio plus 3).

3. Using the same cash flow statement, estimate your total assets and compute an asset-based valuation for the business. 4. Looking at the range of figures that you have just developed, explain why one particular figure is more representative of the value of

the business.

Preparing the Business for Sale When the determination has been made to sell the business, the entrepreneur must begin a process that is somewhat akin to selling a home. There is a need for the entrepreneur to make sure the business looks its best in order to obtain the highest premium possible.

One of the key issues for the survival of the business after the sale is the change in leadership that will occur. Consider for a moment a business we knew that sold equipment to research laboratories. The founder of the business had all the key contacts for the business. When he first tried to sell the business, there were very few individuals interested in the firm. This was despite the firm’s having received the Outstanding Small Business of the Year award from the local government the prior year. The key problem was that there was little value in the business beyond the founder himself. Buyers bought the company’s products because of the founder’s reputation and his unique ability to install the products. Potential buyers did not want to buy a firm whose contacts and relationships walked out the door when the founder sold the business. This story raises important questions for any seller. How will the business run after the founder leaves? How do you transfer the founder’s contacts and reputation to the new owners? There should be a transition plan in place for this transfer in order for any purchase to be viable.

This difficulty is compounded by the reality that most entrepreneurial businesses run a very tight operation where every individual has specific functions and there is little slack available for cross-training. The company founder might handle all of the marketing and sales for the organization. This may include meeting clients, handling contract negotiations, and being the point person for each customer, while the company has another individual handle all of the operational details. Replacing this personal contact person would require that the founder begin to incorporate others in the handling of customers and/or include a new individual to join her in the process of client meetings. All of this requires a significant investment in the future without obvious payoffs in the present. Most entrepreneurs find this quite difficult. These and other types of human resource issues unique to an entrepreneurial business were covered in Chapter 10.

The firm also needs to examine its operations to ensure that the procedures of the business are codified and simplified for easy handover to a new owner. It is a reality in entrepreneurial businesses that the operational procedures develop as the business grows. The effort to put these procedures in writing will go a long way toward making for a more seamless transition. Another operational issue is the accounting of the firm. A system where the founder keeps the books herself is perfectly acceptable and perhaps even desirable when starting up and running the new business. However, a potential buyer wants to assure himself of the accuracy of the financial information. Our advice for ventures considering a sale is to contract with a CPA firm to have it do the following when looking to exit the firm:

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ETHICAL CHALLENGE In the process of preparing his firm to be sold, one entrepreneur sought to make the business look as attractive as possible to prospective buyers. He had the opportunity to make a large sale right before the business would be inspected, which would make his financials look much better. However, the entrepreneur was well aware that the buyer was in bankruptcy proceedings and that he might or might not actually be paid for the large sell. The entrepreneur also had a large manufacturing equipment base that could be made to look better, so they would be valued more with some minor cleaning. This was necessary since the maintenance records for this equipment were sketchy at best, so the value of the equipment might lie in its appearance.

QUESTIONS 1. What are the entrepreneur’s legal requirements in presenting the business to a buyer? 2. Do the ethical requirements differ from the legal requirements in what must be presented? Isn’t it simply “buyer

beware”? 3. How do you as a business owner make sure that the firm looks attractive to purchase but at the same time provide

realistic information?

1. Audit last year’s financial statements. 2. Put all of the statements into a standardized format. 3. Develop procedures for the accounting of all activities. 4. Provide an audit of this year’s financial statements and render an accounting opinion. This effort provides a level of legitimacy to the business and assures the buyer of the accuracy of the financial statements of

the organization. Maintaining an estimate of the value of a business as it grows and develops is the responsibility of the business owner.

However, the entrepreneur should obtain a professional valuation of the business before attempting to actually sell the business. The valuation may turn out to be much less than the owner feels that the firm is worth, and therefore there would be little need to pursue the attempt to sell the firm.

The methods that will be used by the professional valuation experts will likely be very similar to those detailed earlier in this chapter. The entrepreneur would be well served to conduct one’s own estimate and then compare that to what the professional advises. The entrepreneur should actively challenge the analysis and discuss it with the valuation professional. The knowledge that the entrepreneur develops regarding the valuation of the business will help as they negotiate the sale of the business.

Another important aspect in preparing the business for sale is the recording of all the informal practices of the organization. Policies and procedures developed in the life of a new venture should be recorded and available to a new buyer. Issues such as when to order certain supplies, what time to begin closing each day, the process of closing each day, the methods for dealing with customers, payment practices, human resource benefits and policies, and the like,

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must all be codified. Anyone who wants to purchase an entire company should have all of these practices in writing—both for ease of analysis and for clarity of understanding that this provides regarding the inner working of the business.

Specialization within a business, like hospital auditing, can make the process of selling a business more complicated. What are some things to consider?

The business founders also need to plan for the type of sale that will maximize their returns. The best method to use to actually exit the firm will very much depend on the type of business. Businesses that have moved well beyond the founder’s personality will be simpler to sell than those that are intimately tied to the active participation of the founder. Although there are literally thousands of possible ways to construct a sales agreement, it might take some careful forethought and years of preparation work to make the business valuable to an outside investor.

One of the authors recently worked with an established accounting business where the two founders were both in their early 70s. Although they were looking to exit the business, they really wanted a continuing revenue stream. One of the founder’s sons was also an accountant who wanted to take over the company. Unfortunately, neither partner believed the son had the ability to carry on the work of the business in a managing role. Therefore, the two partners began to ponder how they would sell the firm. In the accounting business, as in many other companies, relationships are critical to the success of the business. Rather than make a quick sale that would lead to both founders leaving the firm immediately, they envisioned an opportunity in which they would leave gradually. They also had a specialized customer base that consisted primarily of hospitals. Hospital audits are usually completed on a schedule that differs from that of traditional corporate audits, which could allow a larger accounting business to better rationalize its accounting work flow. At a conference during the prior year, a larger firm had expressed an interest in an association with the partners’ smaller firm. The two partners later approached the head of the larger firm and worked out a deal that included the following:

1. A small up-front cash payment 2. A five-year management agreement with the two founding partners 3. A gradual handover to executives from the larger firm 4. An annuity payment to the founders for 10 years, based upon bookings The result was a smooth sale of the business in which both the acquiring and the acquired firms’ owners were pleased with

the results.

Actually Seeking to Sell the Business Once the decision has been made to sell the business to an outside party, a number of choices are available to the entrepreneur. The most common is to sell the business intact to a third party with the aid of a broker or lawyer. A second very common option is to sell the business to a competitor or to a larger business interested in your location, your position in the market, your product, and so on. A third option is to divest portions of the business that will maximize the value of the business. It is not uncommon for the total value of the firm to be higher if the business is split into separate entities especially if there is real estate owned by the firm or the firm has become highly diversified over time. A fourth option, which is rarely used but is certainly the option most idealized by the business press, is an initial public offering (IPO). The reality is that only a very small number of start-up businesses that end up being very high growth actually seek to conduct an IPO. In fact, for the entrepreneur, an IPO may not be the most profitable means to exit the business. Given the rarity of this type of event, we only mention the possibility of an IPO.

initial public offering (IPO)

The initial listing of a firm as a public entity in the public equities market.

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Not surprisingly, actually putting a business up for sale is a bit more art than it is science. The process of getting the word out that a business is for sale can occur through a variety of avenues:

1. Hiring a business broker who will market the business for a percentage of the sale price 2. Contacting competitors or businesses that have expressed an interest in your business 3. Letting your accountant and your lawyer know that you are interested in selling your business. Individuals in both of

these professions have numerous business contacts and may be aware of individuals seeking to buy a business 4. Contacting your suppliers and perhaps (if appropriate) your significant clients to let them know about your interest in

selling the business

Negotiation Strategies Although it may be obvious to state this, negotiating a sale is the art of trying to reach an agreed price between a willing buyer and a willing seller. Thus, a sale is based in the needs and wants of both parties. For example, if the buyer has other similar businesses in the city and the acquisition of your firm will provide coverage in the final section of the city where they currently are not located or will provide the buyer an outlet in the fastest-growing part of the city, then perhaps a higher price will be offered. Similarly, if the buyer is only interested in the business if he can get a bargain, he might try to pay less. The entrepreneur should not believe there is some absolute price that the buyer will not go above or below. Negotiating to sell the business is a process that the entrepreneur must actively engage in if she is to be successful.

Negotiation is a completely separate field of study, and texts exist for understanding the nuances and techniques that are available. Several important points to keep in mind regarding the negotiation of a sale include the following:

1. Use a professional mediator for anything but the most basic level of discussions. Your lawyer can play this role provided she has the experience. As we discussed in Chapter 9 (the legal aspects of the business), you will want all issues to be clear and specific. Do not make assumptions. Your lawyer can make sure that what you think the contract says is what is actually put in writing.

2. Know the buyer. Ask for as much information about the company that is making an inquiry as they ask from you, or more. If they agree to pay you over a period of years but they default after a year, the result may be that you have a failed business returned to you, with only part of the former value of the firm having actually been paid to you.

3. Retain your own advisors. It is very tempting to save money at this point and allow the buyer to provide the services; however, you are well served by having your own independent advisors.

4. Recognize that there are a myriad of options for selling the business. You may sell the company as a whole, or you can break up the business for maximum value. For example, you can sell the equipment to one company, the location to another, the name to yet another, among other scenarios. The goal upon exit is to maximize your own value.

5. Get cash for the firm. Frequently buyers may want to combine your firm with their firm to create a new business. As a result, the purchasing firm will offer you part cash and part stock in the new venture. If you take stock in the new venture, you are dependent on their success, and your liquidity is often reduced.

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Chris had not been in business six months before his former boss in the mortgage processing unit at the bank approached him early one morning with a question that shocked Chris. Would Chris be interested in selling the business and continuing to run it as the manager? His former boss was impressed by the setup that Chris had achieved and by the rapid increase in his business. Chris had hired a full-time brewmaster, a bar manager, and a significant staff of servers, cooks, and bartenders, only one of whom was a family member. His sister had graduated from the career school she attended and was doing a magnificent job, not only with the books but in handling the whole back-room operation. She had an amazing ability to carry on a conversation with various staff members while completing her work as fast as the work came in.

Flabbergasted at the offer, Chris asked his former boss how much he thought the business was worth. He answered Chris that he didn’t know right then, but he knew a good operation when he saw one. He wanted to have a chance to go over the books, and he asked Chris to think about a few things in the meantime. How much did he think the business was worth? Would he want to maintain an ownership interest in the business? How long might he be willing to commit to running the business if his former boss purchased it from him? Would he sign a noncompete agreement, and if so, how long did Chris think was a reasonable period of time?

Chris quickly got his bearings and told his former boss that before he could see any of the books or even say anything about this, Chris wanted some time to think, and he needed to talk with his family, who had an ownership interest in the place. Chris told him that he would get back to him within a week.

QUESTIONS 1. What would you recommend that Chris do during the next week? Why? 2. The business is so new, why would Chris even consider an offer at this point? 3. What would you advise him to do to determine the value of the business right now?

6. Look to the details. For example, new owners frequently want a noncompete agreement from you once you sell. This will prevent you from directly competing with the new owners for X number of years. However, if your buyout is not substantial, how will you make a living? Be sure you know all the details and ramifications of the negotiations.

Turnaround and Business in Decline LO13-3

Discuss the concept of turnaround and business in decline.

Another related issue that faces entrepreneurial businesses is turning around a firm that is in a decline. It is possible that you have developed a solid business that prospered for a number of years. However, after some time and for a variety of factors, both internal and external to the firm, the business starts a period of decline. The effort to reverse that decline is referred to as turnaround.1

It is very difficult to turn around an entrepreneurial business successfully once it starts into a decline. The fact that these businesses have limited slack* or excess resources results in the businesses’ having a very small leeway to respond to a decline. This is in contrast to large firms with massive resources, which the firms can rely on for years in the face of poor performance.

turnaround

The effort to reverse the decline of a business.

__________

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*“Slack” in this case includes the time available per individual that is not dedicated to day-to-day work.

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The firm must first seek to retrench.2 This activity is analogous to medical situations where doctors must quickly seek to stabilize the patient before they can do more substantive actions. If they do not stabilize the patient first, the patient might die and there will be no value in trying other activities. For an entrepreneurial business, such retrenchment efforts focus on the firm’s gaining control of its cash flow quickly, regardless of the impact to the long-term effort. This can be accomplished by bringing in accounts receivable more quickly, delaying the payment of accounts payable, renegotiating with suppliers so that supplies do not have to be paid for in cash, eliminating staff, and working with employees to cut costs. Once the bleeding of cash flow has been slowed, the firm can move on to more substantive actions.

Remodeling is just one way to help turnaround. What are some other options?

While it is obvious that a huge environmental shift in the economy can cause a serious decline in virtually all businesses, the root internal causes of decline are usually based in either operating or strategic problems. To place it in straightforward terms, operating problems relate to either not selling enough of the product or not being sufficiently efficient in producing the product. Strategic problems are most often related to poor positioning choices. Strategic problems often include diversifying into unrelated domains and not being able to successfully manage the business.

Unfortunately, businesspeople tend to focus on the easiest problems to solve first. These are most often simply symptoms that take significant time to correct and yield very little in overall business results. Therefore, we advise businesspeople to pick the one key reason that the business is suffering. Identify it as either operating or strategic and dedicate the resources of the firm to solving that one immediately.

If it is an operating problem, then the solution should be an operating solution. These solutions include increasing marketing or marketing effectiveness to sell more products if the problem is that sales are down. Alternatively, if the problem is production inefficiency, then the focus should be oriented toward reengineering, simplifying, and measuring. Recall that we discussed quality management in Chapter 12. This is most often the focus of operating solutions and is certainly one of the best places to start the effort to turn around the business.

Strategic solutions rely on exiting those poor strategic choices that have been made over the years. We watched a wonderfully successful firm that installed in-ground pools diversify into backyard furniture and toys (such as swing sets). The business had solid positive cash flow and was looking to find a positive outlet for all the cash it was generating. Within a year the owners realized that not only were they losing money on their new business, but they were also installing fewer swimming pools because their corporate officers were distracted by trying to get the new business up and running. They quickly exited the non–pool installation businesses and redoubled their efforts on their core operations. It took almost two years to return the firm to the point where it had been before the foray into the seemingly related business. Recall that we discussed in Chapter 2 the need for entrepreneurs to evaluate the skills they personally possess before going into a business. In this situation, the entrepreneurs may be quite good at managing a pool installation business, but that does not mean that they will be successful with businesses that appear on the surface to be related. The key to success is not seeking to learn the backyard furniture business (one that involves a wide inventory with no need for installation), but instead, focusing exclusively on the pool installation business. When bad strategic choices are made, exit them quickly.

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The business press suggests for a large, established business that the CEO of the organization and its top management team be changed in a turnaround situation. The argument suggests that these individuals have paradigms, or ways they view the world, that created the decline in the first place. It is therefore supposed to be difficult for such individuals to see the problems and be creative in developing solutions to solve those problems. Entrepreneurial businesses do not have this option since the entrepreneur is running the business. We have found few business founders that are looking to fire themselves. Therefore, it is necessary that the entrepreneur in a decline situation actively seek creative solutions. While not easy to do, this means that they must question themselves and others to a much greater extent than they have done before.3 A well-developed board of advisors, which we have discussed previously, can be a critical aid in this regard. A board of advisors that will provide honest and insightful advice that challenges the entrepreneur can be very helpful in viewing new ways to compete and new ways to overcome the problems faced by the firm.

Implications and Issues Involved in Closing a Business EXERCISE 2

1. Imagine Chris had not been as successful in the bar/ brewery business as he actually has. What do you think he should do to determine the turnaround actions he should follow?

2. What is the greatest barrier such a small service firm faces in such a turnaround?

LO13-4 Recognize the implications and issues involved in closing a business.

It is unfortunate, but bankruptcy may need to be filed by the entrepreneur if the turnaround effort does not succeed quickly enough. The processes/ procedures for bankruptcy are arduous and have lasting impact upon the founder(s), and yet there are circumstances where this is the only viable route. There are several types of bankruptcy that can be filed.4

Chapter 11 bankruptcy allows the firm to be reorganized. When you file a Chapter 11 bankruptcy, the firm receives immediate protection against all lawsuits and other efforts to collect from the firm. At this stage the firm has 90 days to propose a reorganization plan. This plan needs to show how the business will pay off its past-due debts and stay current with its other debts. The company’s banker and other creditors will commonly refer to your account as a “workout.” They will be willing to meet with you and seek a resolution regarding the money that is owed to them. Most creditors will be willing to take less than their full payment with the hope that the strength of the firm will return in the future and they will then be in a position to receive more of their debt repayment. If they do not work with the failing business, they face the potential of the business simply liquidating and the lender receiving only a small percentage of the proceeds from the sale of the assets. This reduction in the amount of money that the creditors ultimately accept is referred to as a “haircut.”

If the firm’s debts are less than $2 million, there is a fast-track version of Chapter 11 that gives creditors far less control than in a larger organization Chapter 11 filing. The fast-track plan must show how back taxes will be brought current over a five- year period. It must also show how those creditors who have pledged collateral behind their debt will be brought current. The unsecured creditors are those who do not have collateral pledged behind their debt, and their debt is the lowest priority. It is generally not necessary to show how unsecured creditors will be paid in this type of Chapter 11 reorganization. During the reorganization process it is possible to terminate leases, contracts, and union agreements that are too burdensome. The bankruptcy judge has the ability to force creditors

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to accept a plan for reorganization if it appears equitable and fair but the creditors are still unwilling to accept it. Unfortunately, there are instances where the business must simply be closed. In this case, a Chapter 7

bankruptcy is invoked. In these cases, selling the business consists of selling the “assets” of the business. The assets of the organization include all of the physical assets (equipment, signs, furniture, fixtures, etc.) as well as any valuable intangibles, such as the corporate name or patents held. The process is similar to that of selling the business, but the owner can add a liquidator to the scenario, as well as the possibility of an auction, as a quick means to clear out of the business.

Two other types of bankruptcy are Chapter 12, used by family farming businesses, and Chapter 13, which is used by sole proprietorships. In each of these cases, the individual files for bankruptcy and includes the firm in his or her personal assets and liabilities. Chapter 13 is intended for entrepreneurial firms with limited debts and assets. The effect of a Chapter 13 filing is similar to that of a Chapter 11. However, since it is for a smaller firm, the process is even easier. For example, the time to approval is typically quicker, and no creditor committee is required.

A final point to be made regarding the turnaround or closing of a business is the protection of personal assets. As was discussed in Chapter 9 (legal), the form of business chosen has many impacts upon the operation of the business as well as the ending of the business. One of those is the extent to which the individuals involved in founding a firm are personally liable for its debts. Incorporating a business (using the Subchapter S, Subchapter C, or LLC forms that were discussed in Chapter 9) goes a long way toward providing limited liability to the entrepreneur. However, many entrepreneurs personally guarantee loans that are made to the company. Doing this negates the limited liability nature of a corporation and exposes the entrepreneur to a major loss of personal assets. While no one starts a business with the intent of failure, the reality is that many do fail. Effectively preparing for that possibility at the beginning of the venture can be a great blessing in the event that the business does not develop as the founder(s) had hoped.

SUMMARY This chapter focused on the exit, harvest, turnaround, and closing of the entrepreneurial business. These are tough but important issues that should be considered when designing a new business. What should be clear is that these activities are as much art as science. Even something that appears as straightforward as business valuation is actually a process that leads to a set of results as opposed to a unique answer. The entrepreneur who chooses to pursue starting a new venture is well advised to develop a plan for harvesting a business as well as handling situations that might require a major turnaround or closure.

KEY TERMS asset valuation capitalization of earnings valuation initial public offering (IPO) market estimation perquisites price/earnings (P/E) ratio turnaround

REVIEW QUESTIONS

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1. Why would an entrepreneur seek to exit a business? 2. How can an entrepreneur be a millionaire on paper yet have no money in the bank? 3. What are the steps in valuing a business? 4. Explain the difference in the following valuation methods.

a. Present value discounted cash flow. b. Price/earnings ratio. c. Asset value. d. Capitalization of earnings. e. Market estimation.

5. What steps should a business owner go through to prepare the business to be sold? 6. What four options does a business owner have to sell the business? 7. Which of these is the least likely to be pursued by the business owner? 8. What are six things a business owner should keep in mind as he enters negotiations to sell a business? 9. What is a turnaround?

10. What are the different types of bankruptcy and when are they each appropriate?

BUSINESS PLAN DEVELOPMENT QUESTIONS 1. As you think about your potential business, what would be the most likely valuation method you can use? 2. Thinking toward the future, if you ever had to turn around your business, what would likely be the key issue that

drives that problem? Is there some means to ensure that you address that problem before your business is up and running?

INDIVIDUAL EXERCISES 1. Develop a harvest plan for your planned business. Have several fellow classmates review the plan for completeness. 2. What are the two or three things that you would want most out of a sale or succession negotiation? 3. Imagine a worst-case scenario. Explain how you have protected your personal assets.

GROUP EXERCISES Form into groups in the class. Go to your favorite search engine and put in the term “small business for sale” and your city name. 1. What website did you identify with firms for sale in your area? 2. How many firms are listed? 3. Pick one business. What is the asking price for that business? 4. What is the basis for that asking price? Can you see one method that they appeared to use from the types of valuation

methods discussed in this chapter? 5. Tell your group about your evaluation of the business that is for sale and whether you think it is a good business

opportunity or not.

ENDNOTES 1. Ndofor, Hermann Achidi; Vanevenhoven, Jeff; Barker, Vincent L. Strategic Management Journal, 34, no. 9, (September 2013), pp.

1123–33. 2. Schmitt, Achim; Raisch, Sebastian. Journal of Management Studies, 50, no. 7, (November 2013), pp. 1216–44. 3. R. Quinn, Deep Change: Discovering the Leader Within (San Francisco, CA: Jossey-Bass Publishers, 1996). 4. R. A. Anderson, I. Fox, and D. P. Twomey, Business Law: Principles, Cases, Legal Environment(Cincinnati, OH: South-Western

Publishing, 1999).

CREDITS Opener: Diana Parkhouse/Flickr/CC-BY-2; p. 235: © Pixtal/SuperStock RF; p. 240: Richard Eriksson/ Flickr/CC-BY-2; p. 246: Phronimoi/CC-BY-2; p. 250: Royalty-Free/Corbis.

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