One day we all have to exit. We either choose the time or eventually the time chooses us. But how do we actually pull this of? How to exit our practice? What do most practitioners do?
How To Exit
We asked Steven Fine of Growth Focus in Sydney to walk us through the options stakeholders have. Steven is a business broker for financial service practices – be they tax or BAS agents, accountants or financial planners. Here is what we learned.
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Confusion is ok
Most stakeholders start out in a state of confusion. For many the question how to exit is overwhelming. Sometimes it is easier to hang in there and just keep going. No decision is also a decision.
We see many principals who have often known for years that they need to do something. But they feel overwhelmed by industry jargon and the myriad of options presented. And this confusion means no action until it is too late. But it doesn’t have to be that way. A well-planned exit can be a good experience – Steven Fine.
Begin with the end in mind
The place to start is just one question: What would an ideal outcome look like in a perfect world? Just visualise this and dream. What does it feel like? You can’t ask for the way if you don’t know where you are going.
Here is link to the questionnaire Steven refers to in the interview. It is designed to help you diagnose the ideal outcome for you.
Once you got your ideal outcome, you can start working out how to get there. You start asking questions and clarify timing, equity, control, responsibilities and finances.
Here are 12 options you might consider.
A. Internal Sale or External Sale
Do you sell to an internal party you already know and work with? Or do you go out and engage a business broker trying to find a third party buyer?
# 1 Internal Sale
The advantage of an internal sale is that you get a smoother transition. You know them. They know you. Staff members are already working with the new owner, so little disruption for them. And the new owner is more likely to preserve what’s there.
Another advantage is that there is usually less due diligence required since the buyer already knows the business inside out. They know what they are buying.
But that also lead to a significant disadvantage of an internal sale. Less due diligence is usually followed by a much looser agreement. A lot is done by handshake or by verbal contract. And that opens the field up for later conflict.
Another significant disadvantage is that you are only talking to one person. There is no competition that could drive the price up. An internal buyer knows your wards and all and is less likely to value your business at market value.
An internal buyer is more likely to require vendor financing, meaning you lend them the money to buy you out.
And your internal buyer is probably an employee, so their buying power is not as great as another practice owner looking to expand.
All these factors will subdue the price you can achieve in an internal sale and limit the cash you will actually walk away with.
# 2 External Sale
An external sale often attracts a much higher price – if done correctly – since the business becomes available to the entire market. Internal partners can bid but they compete against everybody currently in the market. The sale happens in a competitive environment.
If there is strategic value to a buyer, they may even pay more than the market value listed in valuation reports. Something you wouldn’t get from an internal buyer.
The downside is that an external sale can be consuming and disruptive. You have to disclose confidential information to third parties who might be your competitors.
B. Staged Sale or Part Sale or Full Sale
Do you sell staged over time or in one hit? This is a really important question. There are huge risks associated with a staged sale so please read on.
# 3 Staged Sale
In a staged sale there is an equity buy-in with a view to transfer the remaining balance over time.
A staged exit is a popular option and it has advantages. You can help the new partner find their feet. Still benefit from an increase in value. And you can continue working but cut down your hours. So a staged succession can sound really tempting.
But it comes with huge risks attached. Unless it is a very well structured transaction with a guaranteed exit, it is be fraught with danger.
You still have equity in the business, so you still bear part of the business risk. But you have less control now. A breeding ground for tension.
Your new partner will probably face some ‘internal buyer’s dilemma’. The more the new partner contributes,, the more the new partner has to pay you for your remaining share. And so they might not run on full throttle until you finally exit.
Payment runs over an extended time. But cash later is never as good as cash now. Your buyer might have borrowed heavily to buy the first half of your practice. Maybe overestimated future cash flows. And now struggles to find the cash or credit to buy the second half. You don’t have an exit until you have cash in your pocket.
But the largest risk is the chance that the second transition doesn’t go through. You sell the first half with the agreement that the new partner will buy the second half at a later stage. But then they don’t for whatever reason.
Maybe buyers’ remorse settled in after the first transaction.
Or maybe the first tranche was vendor financed, meaning that the buyer didn’t pay cash but just signed a loan agreement with you. Maybe you gave the buyer a low interest rate, and so there is no incentive to pay the loan out.
Whatever the reason, the result is that you are stuck with half a trunk only worth a fraction of what it would have been worth as part of a full sale.
It is hard to sell a non-controlling share of your business to a third party. So you are stuck with your share waiting for the new partner to finally buy you out. And you lower the price again and again until your partner finally does.
Here is Steven with a real life example of how a staged sale can go very wrong.
I had a client who vendor financed 50% of the business to their key employee. The idea was that the new partner would eventually purchase the balance of the business.
Circumstances however changed. And after a few years the new partner no longer had the desire, resources and capacity to purchase the balance. He was keen to continue on as a 50% partner and didn’t want to sell his share. But he also didn’t want to buy the remaining 50%. And he didn’t want anybody else to come in either. In fact he was very particular about who would be acceptable as a new buy-in partner.
So now the original vendor’s options were significantly limited as there was far less demand from other buyers to purchase his 50% of the business. He was left with extremely limited exit options and definitely far less chance of extracting the maximum value from the business on exit – Steven Fine.
# 4 Timed Staged Buyout with Growth Partner
In a timed staged buyout a smaller practice sells to a much larger industry participant, who usually offers significant scale advantages. You can currently see this in the SMSF industry with smaller practices selling to large administrators. It is a staged sale but less risky since you deal with a much larger player.
The buyer purchases a stake with contracts in place to buy the rest over a stipulated time period. That period can range from 2 to 10 years. The buyer then supports the growth and profitability of the business by providing efficiencies and cost savings and sometimes funding. While it might allow you to focus on activities you enjoy, for example client contacts.
# 5 Part Sale
A part sale often makes sense when you want to expand and bring new partners or equity in. But a part sale doesn’t give you a full exit. You still have to transition out of the remaining share. As an exit strategy it carries similar risks to a staged sale.
Unless your focus is on current earnings and not on the final sales price. You could just treat your remaining share as a cash cow. You let the new partner run the practice, collect your earnings and take it easy. And don’t worry about the market value of your remaining share.
# 6 Full Sale
A full sale will probably get you the highest offers across the market. A full sale is a clean cut.
The new owners don’t have to worry about a later transition. They don’t have to worry about other partners coming in. And they don’t have to worry about getting or loosing control.
# 7 Earn Out
An earn-out arrangement means you sell but part of the sales price is determined later. You as the seller must ‘earn’ part of the agreed purchase price payable by the buyer over a fixed agreed period after settlement and linked to certain key performance indicators (KPIs).
Earn out agreements can help when you can’t agree on a fixed price. It reduces the buyer’s risk to pay above market value and allows you to achieve a higher sales price.
To show you an example let’s assume that you want $5m. The buyer is willing to pay $4m. To bridge the gap, you agree on $4 million plus an earn out of $500k over two years linked to KPIs.
The disadvantage of earn out arrangements is that they are a breeding ground for conflict. You might disagree on how to calculate performance. How to account for performance. Or you might disagree on business decisions that affect performance. The list is endless.
The key- take away from all this is: Interpretation of the agreed terms is everything. Test scenarios before you finalise an earn-out agreement.
But there is one more important point to consider. If you stay on to protect your earn-out, you might no longer qualify for the 15-year exemption in Subdivision 152-B since you didn’t retire. So make sure you consider this.
C. Alternative Set ups
The following alternatives are an option but very rare in the accounting, tax and financial planning industry.
# 8 Management Buy Out
The purest form of a management buy out is the purchase of a controlling share in the company by its executive directors and/or managers. This may in some cases be backed by a private equity group. The transaction allows staff or managers involved to enjoy a stake in their own business and be given the opportunity to control the direction of the business.
# 9 Employee Share Option Plan
Simply put, an (ESOP) is a stock equity plan for employees that allows them to acquire shares in the business. A long-term buyout by employees can increase loyalty and be a greater motivator.
General minimums for an ESOP are $4 million in revenue with 20 plus employees and EBITDA greater than $1.5m/year. It allows sellers to retain participation or control during the sale. However, they need to be careful it doesn’t impede a later strategic transaction.
# 10 Private Equity
Private Equity (PE) firms represent investors who pool their capital to buy companies. They typically buy a controlling share of private firms with the hope of later taking them public or selling them to another company.
It may suit owners with a willingness to sell or capitalise the business in 5+ years and is generally only an option when revenue exceeds $10 million with strong growth options. Transactions normally allow existing shareholders to retain a minority interest to align incentives should they remain involved in the business.
A PE firm’s primary objective is a transition to maximise cash flows, not satisfy all stake holders. And with a PE transaction you are selling control. There is no staged exit.
Given all this, the use of private equity is relatively rare among tax, accounting and financial planning practices.
# 11 Merger
Two parties in a merger rarely come to the table as equals. The main point of negotiation revolves around the level of ownership that each company will have in the newly-formed company.
You can do an upstream merger – where a smaller company seeks out a larger firm – or a downstream merger – where a larger company seeks out a firm in order to grow their firm.
A merger might give you a larger market share with less competition and allow for economies of scale and increased efficiencies. It might allow you to wind down to focus on what you love doing.
But it might also result in culture clashes, conflict among merged management and lower productivity among unhappy staff.
# 12 IPO
Initial public offerings (IPO) are expensive and time consuming. They are not a short term exit strategy.
Disclaimer: Tax Talks does not provide financial or tax advice. This applies to these show notes as well as the actual podcast interview. All information on Tax Talks is provided for entertainment purposes only and might no longer be up to date or correct. You should seek professional accredited tax and financial advice when considering whether the information is suitable to your or your client’s circumstances.
Last Updated on 22 August 2019