CHAPTER 4
Transition, Succession, and Exit Planning
Owners' motives, goals, and ambitions matter. It is not possible to have a holistic discussion about middle market M&A without thinking about the owners of these companies. After all, except for private equity or institutionally owned middle market businesses (which count is minor compared to the total population), an individual owner is eventually going to pass their holdings to someone or something; whether the transition is planned or unplanned, it is just a matter of time.
While in classic corporate finance education, publicly traded companies are supposedly mandated to maximize shareholder value above all else, privately held companies usually have a mix of shareholdera objectives. The ideal scenario is to design a transition or exit that achieves all of those ambitions. That cannot happen if plans are made in haste; it requires thought, proactive planning, and positioning for the company and for its shareholders. While we are approaching this from the vantage point of transition, succession, and exit planning, the concepts and ideas presented are relevant for most companies wanting to be prepared for market opportunities, raising capital, pursuing an acquisition, improving their long‐term value, or becoming more resilient against internal and external shocks. We have somewhat conflated and interchanged the terms transition, succession,b and exit planning, as we think broadly about the concepts of creating shareholder liquidity and selling the business (although not every ownership succession plan implies a liquidity event).
While owners have a mix of objectives, a common theme in transition and exit planning is the need for shareholders to increase the market value of their business and position it for a transaction. In Chapter 5, we explore and outline the practical and real‐world drivers of value in transactions, focusing on increasing the realizable market value while decreasing the risk of ownership. Incorporating the needs of the shareholders with the business landscape allows the team to narrow the viable options and focus on practical plans.
The purpose of this chapter is to establish a framework and possible process steps that owners can use to evaluate and filter their options. It is a primer on the topic, not an in‐depth “how‐to.” Our goal is to inspire thought and instigate introspection for the shareholder(s), and to provide an overview for their advisors. Keep in mind that a transition or exit is not always a one‐time event or an external sale: It might be phased over time, creating liquidity for the shareholders; it might be a recapitalization or some type of staged sale; or it might be an internal transfer to employees or family.
Timing plays a critical role in transition and exit planning. Ideally, there is a relatively long horizon and time to plan, position, and transact on the shareholder terms. But usually, real life is also a factor. As we note in Chapter 8, the Dismal Ds often produce an urgency that may not always allow for an orderly process: death, disability, divorce, dissension, downturn and debt, distractions (alternate need for money, and owner fatigue), and divestments.
A transition or exit is successful when three things come together: (1) the owner is personally ready for a transition, (2) the business performance is strong, and (3) the timing of the markets (the capital markets and the selling company's market) is favorable. These combine to provide the key to maximizing value and optimizing the outcome. All three can be affected by inherently unpredictable events. But, more important, all three can and should be prepared for by planning, management, and good business judgment.
First, owners must be personally prepared to sell. An owner should anticipate the ripple effects of a transition, and that it may touch their relationships with a spouse, children, coworkers, and friends. It can also affect their community. Being prepared includes mentally accepting the idea that they will no longer own and control their professional destiny, or at least not in their current business. Often there is a feeling of loss and grief that accompanies a sale. This is sometimes a great hurdle for private business owners, regardless of age. Some owners stubbornly resist facing up to the inevitability of selling; others persist too long in the belief that a family business will pass on to the next generation. Owners who do not properly prepare and plan to accept the personal impact can find themselves second‐guessing their plans or holding out for a deal that will never materialize, and later selling because they must at less‐than‐optimal terms and conditions.
Second, the business must be well positioned to maximize the value to buyers. This means having a well‐defined strategy, a solid management team (independent of the owner/operator), scalable systems and profitability, and, ideally, a strong positive trend aligned with personal planning and market timing. We speak to this in the following section and in the next chapter.
Last is the market. Few companies operate in industries that are not affected by the valuation influences of the public markets. When the broad stock market is doing well, valuations tend to rise in the private markets. The opposite also holds. Other market factors also affect the value of a company, such as interest rates (a low cost of capital generally increases the price buyers are capable of paying), industry trends, and the overall state of the economy. Therefore, it is desirable for a private company to be able to time the business and personal readiness to sell when the broader market is also rewarding owners with overall higher valuations. We address this in more detail later in our discussion about the industry cycles and the business cycle.
Regardless of the drivers and situation motivating the need for the process, thinking through the major areas of analysis should prompt discussion and help the team create a better outcome.
A DECISION FRAMEWORK
We have grouped transitions, succession, and exit planning into one subject because of their overlap and similarity in the context of the middle market. In this section, we lay out a foundation of topical areas to provide ideas for executives, family members, and advisors to include in their analysis. Planning for a transition, succession, and an exit all involve, at their root, assisting the shareholder(s) in deciding what transition or transfer plan is best for them and for their company and when to act on it. The underlying question is not just exit; it is planning the future of the company. That future might include buying, not selling; it might include finding financing for new growth. Although it may not seem appropriate, these ideas play into the possible long‐term strategy and need to be part of a transition discussion.
There are four areas of assessment and inspection that can lead to a short list of real alternatives for any given business transition based on specific owners. Deriving that short list of options typically involves iterating through an analysis and understanding all four areas, synthesizing the information into implications and possible actions. The approach we are sharing is a framework that can work both by itself at a high level and help owners and advisors make better use of the various digital tools, templates, and methods in the marketplace that may enrich the plans and enhance the opportunities for a specific situation.
1. Owner Ambitions and Goals
Regardless of the tools or approach you use, understanding the ambitions and goals of the shareholders is the priority. These vary, but can be narrowed into a few buckets (or categories):
- Why do the shareholders own the company?
The answer to this question often relates back to the origins of the business, career aspirations, family needs, or the other three categories discussed here. Some owners are chiefly motivated by the desire for wealth, some by an entrepreneurial passion to build, and some by the desire to create and maintain a family lifestyle. Some self‐reflection about motive (and gentle probing by an advisor) is an important first step toward discovering the right alternatives for a company's future.
- What are the financial goals of the shareholders and important stakeholders?
Defining financial goals begins with understanding how the company fits within the financial portfolio of the majority and controlling shareholders. Is this their largest asset (which is the case for many entrepreneurs and families)? What are the owners' annual cash requirements from the company and in what form (i.e., W2 income, distributions/dividends, or loans)? If they did not have their ownership, what after‐tax cash or cash flow would they require based on their other assets and stage of life? These discussions should include stakeholders such as family members, key employees, directors, or other third parties that may not show in the capitalization table but whose contribution to the company is important to the owners or affects its future prospects. An example is the business owner who wants to share some of the proceeds of a sale with a long‐time employee, even though that employee does not have ownership or a formalized incentive program.
- What social and community goals does the owner have?
Owners may have social goals that strongly affect which choice becomes a preferred path for exiting their company. The most common examples of this type of goal are a seller's desire to protect the existing jobs of employees, to maintain operations in a specific town or location, or to meet certain charitable giving ambitions. For some owners, these are nice‐to‐have goals; for others, they are musts. An emerging area that is encompassed in this category of goals is the topic of ESG (environmental, social, and governance). We are just beginning to see ESG ambitions entering the purview of both buyers and sellers in the middle market. Nonetheless, social and community goals may impact the type and number of buyers or investors interested in a particular business as well as the terms of a deal.
- What are the owner's legacy considerations?
Legacy can be thought of from different perspectives. For example, transitioning an established business often involves questions about the brand and name of the company, which, for some shareholders, has an emotional and legacy dimension that carries value. Another aspect of legacy can be continued employment of family members and maintaining certain values and traditions. An example of these values could be the quality of service or product that has led to a positive reputation to the name and brand in the market, which the sellers want to be confident will continue.
Defining and clarifying these ambitions and objectives provides the basis for expanding or filtering options, focusing decision making, and aligning actions and next steps in preparing for a transition of ownership.
2. Industry Cycle
Over the past eight years, two of the co‐authors have surveyed shareholders of privately held companies with revenues from $1 million to $250 million from a broad spectrum of industries, after they sold the business. As shown in Figure 4.1, the number‐one reason for selling their company was market timing (or the optimal time to sell based on market dynamics). “Timing” often means a deliberate attempt to market a company given current circumstances, but sometimes it means responding to a highly attractive unexpected offer. In a National Center for the Middle Market (NCMM) survey, 45% of sellers say they acted because an opportunity presented itself, even though they were not looking to sell at the time.
FIGURE 4.1 Primary Reason for the Company Sale (postclosing responses)
Given the importance of market timing, the next step in evaluating exit alternatives is understanding the industry cycle in which the company operates, the market dynamics and trends, and key players and competitive positioning. (An industry analysis also addresses the number‐four reason for selling, competitive pressure.) This information can be invaluable in knowing when to act and whom to transact with to optimize the financial aspects of a sale or to leverage available capital to create liquidity while continuing to lead and operate the business through the next phase of growth and opportunity. A few examples of industry trends include consolidation in a fragmented market, globalization (or the reverse), and digital disruption. If a company is large enough, it might be a candidate as a platform investment to be funded by private equity; or if a business is smaller, the company may be what is referred to as an add‐on acquisition to an existing platform or established industry leader. In many instances, these consolidation plays provide a unique opportunity to sell at a premium. For example, digital disruption in an industry can raise the value of a company considered to be on the cutting edge or lower it for laggards; in either case, changing competitive dynamics and can affect the optimal timing for a sale.
3. Business Cycle
The saying that a rising tide lifts all boats usually holds true in M&A, since many companies perform well when the general economy is doing well. Since 2010, we have lived in an extraordinary time of expansion and growth with unusually low interest rates and low unemployment in the United States. Even with the impact of Covid in 2020, many businesses outside of retail, hospitality, and tourism fared reasonably well. This overall historical expansion of the U.S. economy has enabled and facilitated record valuations and transactions in the middle market.
We also know that the economic weather changes, and sometimes the business cycle leads to higher unemployment, decreasing economic activity; or it pushes the Federal Reserve to raise interest rates and tighten credit. Either can lead to lower valuations, fewer transactions, and more distressed deals. Part of the calculus in preparing to sell involves understanding the impact of the business cycle on a target company and understanding the current timing and trajectory of that cycle. For many businesses, a recession means decreased profits, tighter margins, and sometimes the need to invest capital to weather the cycle. As you can imagine, a recession may not be the optimal time to sell (although it may be an excellent time to buy).
4. Company Foundation
We use the concept of a foundation to assess and identify the relative position and classical strengths, weaknesses, opportunities, and threats of a target company. If we formulate a transition or exit plan by beginning with the end in mind, we must determine the current position and standing of the business and its ability to engineer the solutions to take it to the desired outcome. This critical step of corporate introspection is one that many owners struggle to assess realistically, and is a good opportunity for the right advisor to engage. An owner's perspective is often clouded by sweat equity, years of toil, overestimation of their accomplishments and prospects, and excuses for suboptimal financial performance. Older owners might underinvest for the future. There are also owners—although fewer of them—who do not realize how well run their companies are and what opportunities may wait for them. Either way, having an objective “current state analysis” is important in defining the exit alternatives. Part of the current state analysis is understanding the market value of the company and how buyers and investors think about valuing the target company's business. This is different than a hypothetical value; it is an estimate of the value that is realizable in a transaction given the unique attributes of company.
Synthesizing the understanding and data from each of these four areas should inform the shareholders and their advisors, and allow the team to generate realistic alternatives to optimize the results of a transition process. Of course, the real‐time situation of a company and its shareholders greatly impacts the timing, priorities, and depth of work. An ideal process should result in the following takeaways, along with increased confidence from which to act.
- Defined realistic shareholder and corporate goals and strategy
- An action plan for both the shareholders and management to position for a transition
- Team assignments and timelines with key milestones for implementation
A TEAM APPROACH
Transition, succession, and exit planning in the middle market demand a combination of personal financial, tax, and wealth planning for the shareholder coupled with corporate strategic, operational, and finance planning for the company. This requires a broad skill set and team effort to be developed and executed well. While there is not a prescribed list of roles for the team, we find that having teammates with the following expertise is important to navigate the process to a successful outcome:
- Personal and family financial and wealth planning
- Holistic life planning
- Corporate and personal taxes, including estate planning
- Transaction/M&A law
- GAAP reporting
- M&A advisory/investment banking
- Valuation
- Corporate strategy
- Quarterbacking—that is, the ability to understand and oversee the entire process.
Middle market companies are especially dependent on external advisors, given the relative complexity of the issues and topics that arise and the limited internal resources that typically exist. The key to executing the exit strategy and optimizing the outcome is adequate time and a team of quality advisors that collaborate well working side‐by‐side with the owners.