Entrepreneurship M4 CASE for Paula Hog

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Chapter Twenty One Planning the Endgame

When you started your business it is unlikely that you had a highly developed long-term strategic plan. It is more likely that your business plan was founded on a growth policy to achieve a certain level of market penetration within the first three years, defined by levels of turnover and market share. As your business starts to develop and demonstrates that it can continue to generate profits, you will need to plan how to manage it to grow further, and perhaps faster, and as an owner decide what your longer-term objectives are in terms of wealth creation and the release of capital from the business.

Plainly, the first issue in your strategic planning is to revisit your original growth policy and to decide what changes or refinements you should make to achieve sustained, longer-term growth. Some owners are satisfied with a certain level of profit and personal income and have no entrepreneurial urge to drive the business forward to higher levels of profitability; for them it is sufficient that turnover increases at the rate of inflation, provided that margins and profits are maintained. Effectively, such owners are opting for a ‘zero growth’ strategy, which sounds prudent but, in practice, is likely to prove highly risky. It is often said that a business either grows and prospers or declines and dies; in general terms, this view is supported by empirical evidence. Most of us can think of small and sometimes larger businesses, often family-owned companies, that seem to have adopted a zero growth strategy and are visibly ‘withering on the vine’.

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Organic growth versus growth by acquisition

Assuming that you have adopted a positive growth strategy as a means to generate increasing profits and add value to the net worth of your shareholding, you will need to consider how to achieve the necessary levels of annual growth to fulfil your objectives. We noted in Chapter 18 that, as a basic dynamic of business, growth can be either created organically or purchased by acquisitions.

Again, organic growth can be defined as growth through increased sales, which occurs through the development of the firm as an organism represented by its services and products. In this context, ‘organic’ means structured, organized, systematic, coordinated. Many of the chapters in Part Two and also Chapter 18 focus on the business areas that have to be addressed in order to stimulate and strengthen the organism.

An alternative and faster form of growth than organic expansion is through integration with another firm by merger or acquisition. Integration can be horizontal, that is, between the same type of business, or vertical, that is, between two firms operating at different stages of the supply chain in a business sector, offering complementary services or even operating in different markets.

The two forms of growth are not mutually exclusive, and good decision making by the entrepreneur requires that the horizon is constantly surveyed for both kinds of opportunity, which will better enable business objectives to be achieved. Your surveying activity should include spotting new investment opportunities and alternative means to finance the firm. As with the adoption of a zero growth policy, a company failing to seek opportunities is likely to become stale and run the risk of heading into decline.

Organic growth Drawing on many of the key points from Chapters 7, 10, 13 and 20, we conclude that sales growth can be achieved by several routes:

● gaining market share relative to competitors;Co py ri gh t © 2 01 1. K og an P ag e. A ll r ig ht s re se rv ed . Ma y no t be r ep ro du

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● creating a new market through product innovation;

● adopting a strategy to expand the market;

● following a long-term trend of growth in a given market.

When firms expand they are usually responding to increased orders. At first they will use the same buildings, the same people and the same equipment. In the longer term, other decisions will need to be taken, such as capital investment and staff training.

In theory, organic growth should be less risky than acquisition, and is a route likely to be more favoured by lenders. However, the growth programme must be underpinned by a sound business plan with clearly articulated short-term, medium-term and long- term objectives.

Among many considerations, the entrepreneur must consider whether the existing staff are sufficiently trained, or of sufficient quality, to meet the growth demands, the most appropriate sales and marketing strategy, and the financial implications of the growth programme, notably in respect of cash flow.

Organic growth sometimes requires the investment of additional capital from an outside investor. This can be a further minefield, as the case study which follows demonstrates.

C a S E S T U D Y : Venture capital at the second stage – a cautionary tale

Kevin and Helen built a business together from 2003 in the niche market of corporate business wear for women continuing to work while pregnant, which grew and prospered through to 2007. The highlight of the period was the February 2007 opening of their first shop in London’s trendy King’s Road, which has just the right demographic mix of local residents and service business employees. Retailing in their own premises proved rapidly to be more profitable than the previous formula of franchised boutiques in multiple outlets and pointed the way to opening more shops in carefully selected Greater London locations. However, this bolder strategy would clearly demand additional permanent capital in the business.

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An angel passes

Out of the blue, Helen and Kevin were approached by a well-known figure in the retailing world as a substantial potential equity investor. He had a track record of successful business management and investment in the sector and convinced them of the benefits that he could bring to the business. After a period of detailed planning and careful negotiation, a deal was agreed in July 2007 and solicitors were instructed to prepare contracts. The incoming investor’s funds were to be provided from the exit proceeds of another business investment that had matured and was in the process of being sold.

On the strength of the developing personal relationship and their ‘handshake’ agreement with the investor, Kevin and Helen negotiated leases for further premises in Notting Hill and Richmond that satisfied their expansion criteria. They were days away from signing the Notting Hill lease with the encouragement of their ‘angel’ when the blow fell. In a curt e-mail their prospective partner informed them that he was withdrawing. Apparently, his sale transaction had fallen through and he could not, or did not wish to, invest. A face-to-face meeting or even a telephone call to explain what had happened would have softened the impact.

Dire consequences

The loss of their investor proved disastrous. On the strength of the promised funding, Kevin and Helen had increased their working capital commitments and were unable to cover them. One of the top three firms of international accountancy practices was consulted and they were advised to negotiate a creditors’ voluntary agreement (CVA). Under instruction from the accountants, they entered into a CVA with their creditors in October 2007. On the basis of the plan agreed with them, creditors could expect to receive 39.5 pence in the pound over four years, with a downside of 18 pence if targets were not achieved.

However, the CVA relief from their predicament was short-lived. Their advisers had neglected to warn them how critical service providers would react. As a matter of policy, BT declined to service the company’s customer transactions by telephone because of its CVA status. By the same token, credit card companies refused to transfer payments from customers for goods purchased before despatch. In one case, appeals to the chief executive of the parent company bank were of no avail. Equally, another high street bank demanded a £50,000 deposit before agreeing to conduct business with the company – as good an example of ‘catch-22’ as any in recent commercial history.

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The lessons from this story are clear. Don’t extend commitments in the expectation of new funding until contracts are signed and the deal is closed. And, when a financial crisis arises, question professional advice closely and think through all the consequences of the action proposed. Of course, 20:20 hindsight is easy. For proactive entrepreneurs seeking to accelerate the growth of their businesses by bringing in venture capital, be very careful in your choice of investors. ‘Beware of Greeks bearing gifts’ may be sound advice.

Growth by acquisition ‘Mergers’ and ‘acquisitions’ are usually spoken of in the same breath, and the distinction between the two is mainly technical. In the case of a merger the shares of two companies are combined, either by one company (Company A) issuing new shares to the shareholders of the other company (Company B) in exchange for their shareholdings at an agreed ratio, or by forming a new holding company that issues shares to the shareholders of both Company A and Company B in agreed proportions. In the case of an acquisition, Company A makes an offer for the shares of Company B, with or without the consent of the board of Company B; the consideration may be cash, loan stock or shares in Company A or any combination of the three. Often a cash alternative is offered in place of the loan stock or share elements.

In practice, the result of most mergers or acquisitions is that the owners of one company, or directors in the case of public companies where the shares are widely held, gain a dominant, if not controlling, position in the combined and reorganized business. The term ‘takeover’ is often applied to merger and acquisition transactions, implying a victor and victim. Although used pejoratively, ‘takeover’ is usually an accurate enough description of what has happened or is about to happen. Equally, the term ‘merger’, which implies a meeting of minds, is more often than not a euphemism for takeover. Like marriages, few mergers are made in heaven.

Putting yourself in the position of an objective predator, a firm will wish to acquire when it sees an opportunity to make an Co py ri gh t © 2 01 1. K og an P ag e. A ll r ig ht s re se rv ed . Ma y no t be r ep ro du

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investment with a positive incremental net present value. However, there are other supporting factors that may motivate an acquisition:

● elimination or reduction of competition;

● safeguarding sources of supply or sales outlets;

● access to economies of scale that a larger business can yield;

● recognition that the target company is underutilizing its asset base;

● risk spreading and reduction by diversification.

Acquisitions often provide a quick way to enter other markets and industries. Diversification can make the firm safer and reduce the risk of corporate failure, particularly when the markets in which you are operating show signs of stagnation.

However, diversification into areas where your firm lacks expertise can be risky and costly. You should also address the implications of issuing shares in your company as consideration for acquisition in terms of any potential loss of control.

In pursuing an acquisition policy it is important to keep in mind the motivations of the owners whose businesses you are targeting, as well as your own. As we identified in Chapter 1, entrepreneurs in small businesses tend to value one or more of the following:

● satisfaction in building up a business;

● a desire to lead a particular way of life;

● freedom to make management decisions;

● a desire to keep a tradition alive or perhaps ensure family succession.

While larger listed companies may have the incentive of generating increases in earnings per share by taking over companies at prices that reflect a lower price/earnings ratio, smaller companies are more likely to be sensitive to the vendor’s motivations when structuring their deals. In any event, decisions that consistently ignore the question of wealth creation cannot be taken by either purchasers or vendors.

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Exit and inheritance strategies

Your long-term strategic plan would be incomplete without the inclusion of your personal exit strategy. You may have been driven to consider the endgame already, with the introduction of private equity capital to fund the growth of the business (see Chapter 5). Just as private equity investors will be looking for a degree of certainty that they can realize their investment in your company within a three to five-year period, you should be looking at the opportunity to release a part of your capital within the same time frame.

Owners of most privately owned businesses seek to either pass the business on to the next generation, particularly if the company is a family company, or sell it to a third party, by either a straight trade sale or management buyout (MBO). The MBO concept can also be applied to the succession plan scenario.

Essentially the exit route alternatives are:

● succession plan;

● trade sale;

● MBO or MBI (management buy-in);

● a realization of assets;

● flotation.

Succession plan Many owner-managers will work closely in a team environment over a long period of time. Therefore, it is natural to want to pass the business down to someone in the management team, particularly where there are younger members. The considerations are similar where there are younger family members, although in this case the business may be handed on for nominal or little consideration. In terms of providing for succession in a family company, the current UK capital gains and inheritance tax regime is still probably as favourable as it is ever likely to be.

Insurance policies can play a very useful role in succession planning:

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● A ‘key staff’ insurance policy may be taken out to provide a much-needed cash sum for the company in the event of the death of an owner-director.

● Where there is more than one shareholder, there should be a formal shareholders’ agreement ensuring that shareholder protection insurance is in place. This enables a director’s estate to receive a fair value for his or her shareholding upon death, while ensuring that the relevant shareholding is passed on to the other shareholders.

Frequently, owner-directors continue to maintain control so that they receive a salary or dividend in retirement, sometimes because they don’t trust their children/successors to provide them with a secure source of income. For this reason, the owners should plan to build up a substantial pension fund as well as making a sensible provision for savings.

In the event that the chosen successors have little capital, and provided that the company is sufficiently liquid, it can create cash for the departing owner by purchasing its own shares. With an effective current capital gains tax of 10 per cent (see Chapter 15), it is better to exploit this advantage wherever possible rather than receive sums subject to income tax.

Trade sale In many cases a trade sale is the natural exit route. For third-party private equity shareholders, it will be the preferred route in the absence of a sustainable flotation within the time frame for the manager’s planned exit. At the end of the day, most people have a price that they will accept, and the wealth can be passed down to family members.

A company sale can take one of two forms: a sale of shares or a sale of assets. It is highly preferable for a vendor to sell his/her shares. This ensures that business taper relief (see Chapter 15) and retirement relief, if applicable, can be claimed. It also avoids the potential double taxation charge arising from a sale of assets.

In an assets sale the company will sell the assets and make chargeable gains subject to corporation tax. The owner will then pay

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income tax when the profit is extracted. If an assets sale is unavoidable, the most efficient way forward is usually a pre-liquidation dividend. In practice, it is well worth encouraging the purchaser to purchase the shares in your company, even if it entails passing on a discount or giving indemnities and warranties that would not be demanded in an assets sale, provided that the latter are not too onerous.

However, a trade sale of your company’s shares may not be quite so straightforward as it first appears. Perhaps the purchaser will ask you to accept shares in its company for a part or the whole of the consideration. If the purchasing company is listed on the London Stock Exchange you may be willing to accept a part of the consideration in shares, given that a share exchange does not attract capital gains tax until such time as the shares received are sold. Nevertheless, before accepting this alternative be sure that there is an active market in the shares and that you are free to sell them over a reasonable period. If you are in any doubt about your ability to convert the shares into cash, be sure to insist on arrangements for them to be placed in the market on your behalf.

Another quite common requirement in trade sales is for the purchaser to insist on an ‘earn out’ element in the payment of the purchase consideration. Under this kind of arrangement you will receive only a part of the purchase consideration on completion of the transaction, and the remainder in one or more instalments over a further period, with the price adjustable by reference to the audited net profits before tax.

This is a reasonable approach if the final reckoning relates to a financial year that has ended before the acquisition was completed and the audited accounts are not yet available. However, calculation of the outstanding consideration is often referenced to an accounting year that is not yet complete or to one or more financial years ahead, and such conditions give rise to a number of uncertainties.

You may be able to sell the company without some element of earn-out but, if not, there are several conditions that you should strive to include in the part of the sale agreement that refers to the earn-out period:

1 A sufficient part of the purchase consideration to be paid upfront in cash on signature of the agreement. This is your

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‘drop-dead’ money of which you can be certain if the rest of the transaction is delayed or fails to be carried out.

2 Your continued employment by the company, if the deferred element relates to a future accounting period, as a director and on no less than the same terms that you enjoyed prior to the sale of the company. Your employment should be the subject of a written service agreement.

3 An undertaking from the purchaser in the form of a shareholders’ agreement that for the financial periods to which the earn-out provisions apply, no parent company management charges will be levied, no additional senior management appointed, no capital expenditure incurred, no loan capital introduced, no new share capital issued and no dividends paid without your express written consent.

The third set of provisions is necessary to ensure that neither pre- tax profits nor shareholders’ funds are deflated during the earn-out period, and your remaining shareholding is not diluted by actions of the new controlling shareholder unrelated to normal trading.

If the purchaser requests that you remain with the company as a salaried director for a minimum or indefinite period of time, irrespective of any earn-out arrangements that may be agreed, do not be deceived into thinking that your trade sale is anything other than a takeover of your business. Whatever the intentions of the parties at the time of the transaction, and however flattering an invitation to stay on may seem, it is extremely unlikely that you will still be employed or play any active part in your company’s affairs 18 months after the sale. Of course, there are recorded cases of vendors who have gone on to take increased responsibilities and senior positions in the group of which their company has become a part, but such cases are few and far between. More commonly, the vendor finds it difficult to adjust to a new situation where he or she is unable to take decisions unilaterally, or where the management ethos or business practices of the group are incompatible. Moreover, there is likely to be a band of thrusting young managers to whom the vendor is now exposed, who are confident that they can run the business better.Co

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A service contract will help to ensure that the final parting is financially acceptable, but with the gift of hindsight, you might wish that you had negotiated a higher drop-dead element in the purchase consideration, if there is still an earn-out payment outstanding. As a general recommendation, you should try to ensure that at least two-thirds of the total purchase consideration in a trade sale is paid in cash on completion.

MBO or MBI A management buyout (MBO) is often a good way of exiting from a business. In fact, an MBO may not involve the existing management at all, and could be a scheme led by institutional investors, involving the insertion of a new management team into the business, thereby creating a management buy-in (MBI).

Similar considerations apply as with a trade sale. However, earn-out provisions and service contracts for the vendors are less likely, as are earn-out provisions. In raising institutional financial backing, the new management team will probably have developed a business plan of its own that involves ambitious growth targets and major changes to the way in which the business has been run previously. You are unlikely to be a welcome guest at the feast that follows.

Realization of assets A realization of assets is often a scenario forced on the owner because of poor trading, and takes the form of a receivership or liquidation. In cases where there are difficulties in making a trade sale on the best terms or there are peculiarities in the business, such as a total dependence on the continuing presence of the original owners, the owner-director(s) may decide to wind up the company voluntarily, following either a sale of the assets and ongoing trade, or a planned closure of the business. In any event, good timing and prompt decision making will help to maximize the outcome.

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Flotation A public flotation on the Alternative Investment Market (AIM) of the London Stock Exchange, or even a full listing for larger companies, can be the ultimate exit route over time, and entrepreneurs may be attracted by the prestige of leading a quoted company. However, the listing process is fraught with complicated pre-flotation requirements, and the post-flotation maintenance of the listing is a continuing burden.

The actual process of flotation is expensive, and involves the appointment of an accredited nominated adviser or sponsor, solicitors to the issue, reporting accountants, a corporate broker and financial public relations consultants. The decision whether or not to go public should be appraised long before the decision is finalized, after evaluating carefully the alternative strategies and contrasting them with the flotation model. For a step-by-step account of the flotation process and post-flotation management issues, you may wish to consult Floating Your Company: The essential guide to going public (Reuvid, 3rd edn, Kogan Page, 2007).

If all goes well, new capital can dramatically increase your company’s potential growth in many different ways, and is the stepping stone to substantial financial rewards through future share sales. However, the best-laid flotation plans can be blown off course by market developments beyond the influence of your advisers or yourself, such as the 2001/02 ‘bear’ market, which caused a number of companies to defer or break off their flotations, or the present plunge in the financial sector following the ‘credit crunch’ of 2008 that has caused companies to defer their independent public offerings (IPOs).

The main disadvantage of flotation is its inadequacy as an exit strategy for the owner-managers of the company. There will be restrictions on the disposal of the owner shareholdings for several years, and invariably the owner-managers will be required to remain in office for an extended period following flotation.

Bowing out In Chapter 1 we introduced the SWOT analysis as a planning tool and suggested that the same assessment exercise to which you

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Checklist

subjected your business start-up plan and your own capabilities as an entrepreneur could be carried out at any time in the life of a business. One time when the SWOT tool is certainly appropriate is if you have reached a point when you have to question the future direction and prosperity of the business or, indeed, its ability to survive. However unwelcome an experience this may be, it is better to carry out the analysis as soon as you begin to have serious doubts rather than wait until poor trading forces you into an assets realization programme under an administrator or receiver.

There are many external reasons, probably beyond the control of its owners/directors, why a previously healthy business may fall into decline. All too often the deterioration occurs because the management has failed to anticipate changes in the business environment or to plan and manage the internal change and development programmes necessary for continuing growth. The hardest lesson for any entrepreneur to learn and accept is that he or she can no longer make a useful contribution or that his/her continuing management presence may be a liability to the business. If you find yourself in that unhappy position, take a deep breath and get out.

● As your business grows profitably, revise your original growth policy to achieve sustained, longer-term growth. Zero growth strategies are risky.

● Growth can either be created organically or purchased by acquisition.

● In theory, organic growth should be less risky than acquisition, and is a route more likely to be favoured by lenders. Consider whether existing staff are of sufficient quality to meet growth demands, and the cash flow implications of the growth programme.

● Where a merger or acquisition results in the owners or directors of one company gaining control or dominance of another, in reality the transaction is a takeover.

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continued

● In pursuing an acquisition policy, keep in mind the motivations of the vendors. The question of wealth creation is paramount for both purchaser and vendor.

● Succession plans can provide for exit payments to owners through the company’s purchase of its own shares, which are subject only to capital gains at the current preferential rate.

● Owners should plan for retirement by building up pension funds rather than expect to continue drawing salaries or dividends subject to income tax.

● Trade sales through the sale of a company’s shares are preferable to a sale of assets for the vendor. The latter is subject to double taxation charges.

● Trade sales can involve ‘earn-out’ elements in the payment of the consideration. Take care to secure a substantial cash payment on completion and written undertakings to ensure that neither pre-tax profits nor shareholders’ funds are deflated, and your shareholding is not diluted during the earn-out period.

● MBOs and MBIs involving institutional investors are an acceptable variation on trade sales. If you remain an employee after any kind of trade sale, do not expect your employment to continue beyond the short term.

● Asset realization through a voluntary winding-up of the company may be appropriate following a sale of the assets and ongoing trade. Good timing and prompt decision making will help to maximize the outcome.

● Public flotation of your company may be the stepping stone to substantial financial rewards, but there will be restrictions on the disposal of owner shareholdings for several years, while owner- managers must stay on post-flotation.

● When you can no longer contribute usefully to the business, plan your exit.

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