WV Executive

The demographics of the United States suggest that major changes in the ownership of privately-held businesses will occur in the next 10 years. Over 50 percent of the owners of these businesses are at least 50 years old. Given the demographics of our state it is likely that this percentage is even greater in West Virginia. I refer to this as the 50-50-10 Imperative. I believe we will see a greater transfer of privately-held business equity during the next 10 years than in any decade in our country’s history—perhaps to be exceeded only by the following decade.

In more than 35 years of serving and advising West Virginia businesses it has been my privilege to meet, observe and get to know many outstanding business leaders and their businesses. I’ve worked with businesses at the start-up stage, the exit stage and each stage in between. This series of articles, beginning with the one that follows, describe the lifecycle of equity capital in a privately- held business. It is offered for the purpose of helping privately-held business owners build and benefi t from the value of their investments in their businesses.

A Case Study

Successful business exit strategies are built upon the foundation of solid leadership. The story of Teresa Shelton* and Systems Learning, Inc. illustrates that principle well. Teresa’s father, Gerald founded the business and nurtured it from a start-up through the early stages of its development. Systems Learning grew in size and profitability—though sometimes in a three steps forward and two steps back pattern—through Gerald’s tenure. The number of locations and employees grew and the business prospered under Gerald’s leadership.

Teresa grew up around the business, but after graduation from college gained valuable experience by working for a major company located outside West Virginia. After a period of several years, she returned to enter the business on a fulltime basis. She considered it a privilege to work alongside her father. In fact, she had the opportunity to learn many aspects of the business before finally succeeding him as president shortly before his retirement. It is important to understand that while Gerald left Teresa in charge of the company, and left her a majority of its voting stock, her three brothers were also left ownership in the form of non-voting interests. Not incidentally, while this ownership structure has its own dynamics and has been a challenge to manage at certain points, such potentially stormy waters have been navigated relatively smoothly.

In the years since that transition Teresa has continued to build the business in size and scope. Today it operates in more that a dozen states and is a substantial player on the national stage within its industry. The story of its success would be interesting in its own right, but the purpose of this article is to describe the current stage in the lifecycle of its equity. Today Systems Learning Inc. is owned by four families—Teresa’s, which owns 25 percent of the total equity and 100 percent of the voting stock—plus the families of each of her brothers, who own 25 percent of the stock.

The Exit Stage

The company stands at a challenging point in its history. Teresa is now much closer to the end of her career than the beginning and while one of her sons may be interested in the business, it is by no means a certainty that he will succeed her. Furthermore, her brothers would now like to have their interests cashed out. Understandably, they are uncomfortable with seeing the business through a transition from Teresa’s leadership to that of someone who is not a family member. They have asked Teresa to develop an exit plan for them.

Building the Foundation

One of the biggest problems I see with developing exit plans for business owners is that the necessary foundation has not been laid for the exit. Therefore, the exit options may be very limited. Limited options almost inevitably equate to a lower business value, a reality that many business owners realize only too late.

What is the foundation? It consists of three important dimensions:

1. Cash Flow—In short, “cash is king.” Except under unusual circumstances, the value of a business is directly related to its ability to generate sustainable “free cash flow.” Essentially this is the amount of cash flow the business can return to investors after meeting all its current obligations and after adequately reinvesting for a viable future. This last aspect is sometimes overlooked. For instance, short term cash flow can always be increased by neglecting maintenance expenses, but that would not allow for a viable future and would diminish return on investment over the long run.

2. Infrastructure—Simply put, a business must have in place the systems to enable it to function at a consistent level. The next article in this series will discuss the “Building Value” stage of the lifecycle of business equity and will explore such issues more fully.

3. Successor Management—This article focuses on the exit of equity from the business, but this often accompanies the exit of management and leadership talent as well. In such a case, ensuring that successor talent exists within the business is essential.

In the case of Learning Systems, however, the foundation has been carefully constructed so the Company has a variety of options available to it. While all of those discussed below are not a fit for Systems Learning, they are presented in the interest of a more complete discussion of exit planning for a privately-held business.

The Equity Exit Strategy

An exit strategy for the equity in a business can be composed of many parts and utilize one or more basic platforms. The choice will depend on many other factors including the strength of successor management, the opportunities for future business growth and the portion of the equity base being transitioned. Following are some of the more common platforms:

Sale of the Business to an external Third Party—Many business owners assume that when they are ready to exit their business, an external third-party purchaser will appear and be willing to pay full fair market value for their business. Unfortunately, that doesn’t usually happen. There are two basic explanations. First, the timing may not be right. The right time for you may not necessarily be the right time for a potential purchaser or better yet, more than one potential purchaser. Second, getting the best price depends on you having other viable options. If you have a single focus and no other real options, you may find that the price is much lower than you would have liked.

Employee Stock Ownership Plan (ESOP)— ESOPs have considerable advantages, as noted elsewhere in this article. To work well the company must be well managed. If the owner who is removing equity from the company is leaving, or reducing his or her time commitment to the company, this need must be filled by others. One quick caution: I refer to companies with ESOPs as “quasi-public” companies. The Board of Directors of an ESOP-owned company now has a new and probably much larger group of owners to which it has responsibilities.

Private Equity—There are now more that 1,000 private equity funds in the U.S. seeking to take ownership positions in companies—and they have an estimated $1 billion of available cash to invest. In general they are interested in companies with at least $2 million in annual EBIT (earnings before interest and taxes), and they want to be involved only for five years or so. Basically, private equity funds seek to grow the business rapidly by implementing more professional systems, adding members to the management team (sometimes replacing current members) and by making acquisitions. They hope to build the value rapidly, then to sell the business to a strategic purchaser as their exit strategy.

Sale of the Business to an internal Third Party—Often the best buyer is already in the business. The seasoned, knowledgeable employee who shares the owner’s vision for the business and can manage the business well may provide the best exit strategy. One problem: that person often has very limited means. Last fall our firm, along with the White Planning Group, sponsored a seminar by John Brown, author of the book “How To Run Your Business So You Can Leave It In Style,” who explained his approach to solving this problem.

Family or Charitable Transfer—This approach may involve gifts or other transfers of equity that are for less than full market value.

In the case of Systems Learning, the stage is set for the selection of a basic platform and a development of an exit strategy. The next step is the selection of a basic strategy and the development of the steps which comprise the exit plan.

Conclusion

If you intend to remove any substantial equity from your business, you would be well served to plan this exit carefully. Furthermore, such planning is best done well in advance of the desired exit so that appropriate alternatives can be explored and the maximum value can be obtained. Simply stated, without sufficient planning on your part, the value of your equity position may diminish, perhaps considerably.

Studies show that many privately-held businesses are expected to change hands in the next decade, yet many of the owners of these businesses have done little or no planning for their exits. I believe the benefi ts of exit planning are considerable, not only for the exiting owner but also for the many customers and employees who will remain, and thus for the business itself.

Furthermore, I believe that there are important implications for the West Virginia economy. A great deal of West Virginia business equity could evaporate over the course of the next 10 to 20 years if the thousands of exits which will occur are not suffi ciently planned and executed.