May 2013
Succession and exit planning for business owners OVERVIEW Business exit and succession planning was practically unheard of 10 years ago; however, these days the astute business owner understands that it is a significant aspect of the success of their business. In his book The Seven Habits of Highly Effective People, Steven Covey says his second habit is to “begin with the end in mind” (Covey, 1999). The “end” objective will vary from business owner to business owner. For many it will be to achieve a capital gain on the sale of the business, with a view to using the funds for further investment or retirement. Alternatively it may be to build an organisation which will be passed on to others, for example, family. However, whatever the goal, it cannot be achieved without planning and forethought. By using a number of “value” steps, the desired outcome can be achieved regardless of the type of business enterprise. Did you know? In Australia more than 50% of business are currently failing — a result of bankruptcy, liquidation, death or serious illness, divorce, or simply walking away and locking the doors. Many because no succession planning has been undertaken by the business owner.
FEATURED CONTRIBUTOR Craig West CEO, Succession Plus
LEARNING OBJECTIVES After reading this article you should be able to:
› Define the concept of and rationale for strategic succession planning. › Explain the steps involved in the business succession process. › Evaluate the application of succession planning to different types of businesses.
KNOWLEDGE AREAS AND ACCREDITATION Knowledge area: Practice Management (30 minutes). FPA CPD points 0.5 Dimensions: Capability, Attributes & Performance (FPA 005868). AFA CPD points 0.5 (AFA 01022009). FBAA CPD points 0.5. May 2013 • 1
Succession and exit planning for business owners
WHAT IS STRATEGIC SUCCESSION AND EXIT PLANNING? Strategic succession planning covers all aspects of the business, but importantly it focuses attention on the final outcome. What is the owner actually trying to do? Build their business? Fund their retirement? List on a stock market? Raise further capital and grow? Pass on the business to other members of the family? Strategic succession planning means having a detailed and documented plan covering every aspect of the business, so as to continually move it closer to the ultimate exit outcome. However, most business owners are so caught up in running the business on a day-to-day level that they do not have the time, effort and attention to focus on the end outcome. Consider Most people go into business not only to earn income, but also to build the value of their equity and to sell — statistics tell us the majority do not get to that point.
WHY STRATEGIC SUCCESSION AND EXIT PLANNING? A survey conducted by the Monash University Family and Private Business Research Unit in the late 1990s predicted that over the coming years, 60% of private business owners will be approaching retirement, (the first Baby Boomers actually turned 65 in 2011), and the ensuing transfer of ownership of assets and business will equate to approximately $607 billion (Smyrnios et al, 1997). Consider Investing time to develop a strategic succession plan is one of the most important financial decisions a business owner will ever make, because without one the value in the business will retire when they do. The Monash survey predicted one-third of Australian family businesses will change CEOs; and while 53% were sure that the successor would be a family member, 83% did not have a succession plan in place (Smyrnios et al, 1997).
WHEN IS THE RIGHT TIME? Strategic planning is all about time. The simplest analogy is to ask whether or not an owner would consider approaching a real estate agent today with a view to selling their property this coming Saturday. Most real estate agents could actually achieve this, but without any time to market the property, prepare the property for sale and review their database of buyers, the price they achieve will not be the real value of the property. Similarly, most businesses require a minimum of five years to maximise their value, and prepare to extract that value successfully. We often see stories in the business media of well-known wealthy entrepreneurs making substantial money “trading” in businesses. They invest, build or grow the business, reduce the risk, and then exit profitably, making substantial gains on the investment over a few years. This is the best illustration of getting the exit strategy right; it is the ultimate test of success for these investors. If they don’t exit correctly they make no money! Addressing Stephen Covey’s second habit, “Begin with the end in mind”, the right time to begin succession planning is when an owner opens/buys/starts the business. The owner should be able to track every strategic decision they make on the business journey back to their end goal. What is the exit strategy, and is the decision they are making today getting them closer to that strategy outcome?
HOW STRATEGIC SUCCESSION AND EXIT PLANNING IS DONE One of the key things that prevents most business owners focusing on this area is a lack of knowledge and understanding that business succession and exit planning is actually a process. The more focus 2 • May 2013
Succession and exit planning for business owners there is on moving through this process step-by-step to achieve a successful exit, the easier it becomes for a business owner to engage and go down this road. A detailed process divided into steps can assist business owners to design and implement a customised strategy to maximise the value of their business. This in turn can lead to an exit which will ultimately help achieve their objectives.
THE SUCCESSION AND EXIT PROCESS Stage One: Identify value The first stage of the process is to identify goals and outcomes, that is, what will be required in terms of retirement planning and financial needs going forward? What exists currently in terms of business value and personal assets? A comprehensive review (or fact find) of the business should lead to a detailed report of findings and recommendations. The review should look at the business from the same perspective that a buyer would take and analyse the business risk in terms of documentation, compliance, legal, HR and other issues — to ensure the due diligence process does not cause problems with any future transaction. The report should include a comprehensive financial analysis to highlight any area within the business that requires further development or improvement. It should contain recommendations and suggested changes to the existing business structure for ease of operation, flexibility and effectiveness in terms of taxation outcomes, and the ability to provide for future transfer of ownership. Based on the detailed analysis contained in the report, projects to manage the priorities, exit options and owner’s goals, implementation plan and timeline can be prepared.
Stage Two: Protect value There are many inappropriate ownership structures which do not protect assets effectively, and which do not reflect the owner’s financial planning and lifestyle goals in terms of long-term wealth accumulation. Undertaking a financial planning process determines the funding required for retirement, or, after exit from the business, the most appropriate structures to own that wealth. In addition, a financial plan needs to manage the risk of unexpected events in terms of accidents, sickness and even death. The plan should include a review of existing risk management arrangements, and what legal agreements have been implemented to manage unexpected outcomes. This will ensure the business owners, and the underlying asset value of the business, is protected in case of an accident or sudden illness. In the same way, in most small businesses there are several areas that are typically high risk. The most common of these is owner dependence, as most small businesses find it very difficult or even impossible to operate without the hands on involvement of the business owner. In many cases, the business owner is the primary, (or only), salesperson who derives most of the revenue for the business. They may also hold detailed intellectual property or technical skills that are vital to the performance of the business and not shared among other staff. Business owners should look at their operational risk, as there are always multiple areas within the business that could be improved upon and the risk reduced. Obviously, reducing risk is a significant issue as it forms one part of the valuation formula and in every case the lower the risk in the business, the higher the valuation.
Stage Three: Maximise value Many business owners are looking to maximise the value of their business so it matches their retirement planning outcomes. This situation requires a review of available exit options, and an agreement as to the most appropriate strategy given the business owner’s timeframe and financial position. A strategic plan will need to be developed which maps out the strategic initiatives for the business over the next five years. Benchmarking can be used to identify growth and performance improvements, while implementing key recommendations from the business report, (developed when identifying the value of the business). At this time it is also recommended to project manage a May 2013 • 3
Succession and exit planning for business owners restructure (if required), as well as reviewing risk issues including insurances on key people and assets. A key aspect is to get the business model right. How does the business make money? There is a simple spectrum identifying the different types of businesses – from “boutique” to “scale”. Neither end is better than the other. Each represents a different model for running a business and importantly there are different value drivers at each end of the spectrum. All businesses sit somewhere on this spectrum, and maximising the value of a business depends upon the owner’s ability to recognise where it currently sits, and how to improve its position. Some examples are included below.
Scale businesses: the McDonalds model McDonalds is a true scale business — firstly, it is large (though this is not the most important factor), it is highly systemised and structured, its value lies in volume and its owners are not tied to the business day to day. This is a highly efficient factory for delivering fast, convenient take away meals (initially hamburgers but now a wider range of meal options). The typical McDonalds franchise in Australia sells for about $1 million. Why? They make money and are easy to run. Some basic facts include:
› They are large in size: 31,000 stores in 119 countries. They serve about 47 million customers per day and have over 1.5 million staff internationally.
› The average age of a McDonalds store manager is just 21 years old. How does this work? McDonalds have policy and procedures manuals for everything. They have a training program second-to-none and staff are constantly monitored and measured. The policy and procedures manual includes details on every aspect of store operation. If the thick shake machine is not working, there will be a page on how to fix it and if that doesn’t work, a page on from that explains what signs to put up explaining the issue to customers. What businesses have this level of systemisation? McDonalds has done this by necessity — they have a young inexperienced workforce and they rotate staff often. As an added benefit it adds incredible value. In terms of scale and adding value, McDonalds are very successful.
› As anyone who has ever eaten in a McDonalds store will know, they always ask “Do you want fries with that?” It is estimated that this question alone makes them US$22 million per day.
› McCafés, (actually an Australian idea), are estimated to add up to 60% turnover to stores they are added to.
› McDonalds drive thrus, when added, nearly doubled the turnover of stores on main roads. This is simply another version of adding scale to an existing operation. No-one expects an average business owner to have a drive thru or employee 1.5 million people. However, the lessons are obvious — in a scale business, volume is the key. This is not volume based on discounting, it is volume based on working out how to ask “Do you want fries with that?”
Boutique: niche businesses “Boutique” businesses are quite a different prospect to “scale” as they are not focused on volume but on the opposite, they are speciality businesses servicing a niche market or clientele. Typical words to describe boutique businesses are “premium” and “exclusive”. These businesses service a niche and the very best ones drive themselves further and further into that niche, specialising in their service offering and their product focus until it is boutique. For example Rockpool — a boutique seafood restaurant in the Rocks built around celebrity chef Neil Perry — high end premium price, premium wine list and really strong service. Rockpool only does seafood, but it does it very well; it is expensive and exclusive — a true “boutique” business. Neil Perry is the consulting chef for Qantas, but only for business class and first class. This supports the premium positioning that this restaurant and its chef enjoy.
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Succession and exit planning for business owners It is important to recognise how we add value in these businesses — simply put, drive further into the niche — specialise, and improve service and product. Become more premium and more exclusive — price is never an issue in these businesses.
No man’s land In the middle sits — “no mans land”. This exactly what it says — no man wants to be there! Simply put, this is when you try to serve a hamburger in Rockpool, or try to cook lobster mornay in a kitchen at McDonalds. Many get caught trying to produce and serve a product that the factory is not designed for. Due to the cash flow pressures of start-up, or ignorance of real value drivers in business, many business get caught in this trap and end up talking on clients/products/markets that are not in their target group. The result is that they move their business away from either end of the model and towards no mans land — where value reduces. “No man’s land” can happen in professional firms — accountants, lawyers, financial planners, etc. They build a factory based on either:
› boutique (for example, an accountant in country NSW who services only 100 clients in total — no matter what. He gives them premium service and answers their calls from overseas in the middle of the night); or
› scale (for example, H & R Block or ITP — highly efficient factories for churning out tax returns as quickly as possible). Both have profitable successful businesses, but they shouldn’t cross over — but often do. Often, a financial planner who services only high net wealth individuals will get asked to do a favour for a big client, for example “Can you look after my mother/friend?” This person doesn’t fit the profile and isn’t a high net wealth client. However, they say yes to keep their large client happy and therefore now have a client who doesn’t meet their factory! Repeating this process over time can result in the business ending up in no man’s land! What is the solution? Revise the situation. Sell a parcel of clients that don’t match, open a new office that handles just that type of client, refer the “mismatched” product or client to another business, and/or enter into agreements that stipulate you will only accept clients that are a perfect match for the existing business.
Employee involvement Considerable success can be achieved by implementing a management buy in, where key people within the business are retained and incentivised with a vehicle or financial reward. For example An improvement in performance may be achieved through the adoption of an employee incentive plan. This could be an employee share plan to purchase shares based on a profit share arrangement, with those funds being reinvested into the equity of the business rather than taken as cash payment. This plan could operate over an extended period, and could have the added benefit of attracting, retaining and motivating key staff within the business who now have a vested financial interest, along with the business owner, in maximising the value of the business. A method such as the Ownership Thinking Management model, which endeavours to encourage employees to think and act like owners, either dovetailed with an employee stock ownership plan (ESOP) implementation or standing alone, empowers key staff, eradicates entitlement thinking, and through a series of rapid improvement plans, shows very real improvement in productivity and profitability. This “maximise value” stage of the process can also identify the most appropriate buyer for a business. A listed company as a purchaser or a strategic sale can often double value. In any event, just knowing which exit is the most suitable and what can be done to get a better result, can focus a business owner’s attention and efforts on making the business more efficient, profitable and less risky — all of which add to the value. It can even lead to business owners subsequently deciding not to sell May 2013 • 5
Succession and exit planning for business owners the business, as, in its “new form”, it is less stressful and better matches their lifestyle and retirement planning needs.
Stage Four: Extract value This stage involves implementing the agreed strategy once all of the restructuring and value enhancement projects are complete, to ensure maximum value. Depending upon the most appropriate strategy, this stage will involve transactional issues like legal advice, taxation and accounting. A strategic approach is maintained to maximise the outcomes and ensure they are aligned with retirement planning objectives. The preparation of a detailed Information Memorandum and Due Diligence documentation is an important aspect of maximising value. Importantly, at this point, the aim is for a strategic sale to a buyer who pays more than anyone else because they absolutely have to have the business. They can leverage the value that has been created — allowing them to pay more than most potential buyers believe the business is worth. Why would someone pay more than the business is “really worth”? To quote Warren Buffett, who is probably the world’s most successful investor, “Price is what you pay and value is what you get”. This means finding a reason why someone can extract far more value from the business than most other buyers are able to extract. There are many examples of these types of transactions. For example Some simple hypothetical “deals” include:
› The value of a business that designs voice recognition software (such as that used in Siri in the iPhone 4S) is far higher for Apple who has the market position to leverage that technology, than for a company which is hoping to add the feature to a new unproved product with a limited market.
› The value of MYOB was significantly enhanced, (in its Nov 2011 private equity sale for 11.3 times earnings), to a buyer who could leverage the more than one million Australian and New Zealand businesses who use MYOB on a regular basis, to manage their accounting and compliance needs. According to Bizexchange, given that the average Australian small-to-medium enterprise (SME) is selling for something like two times earnings, these strategic exits can add substantial retirement funds.
In order to prepare for and execute such a strategic sale, there needs to be persistent focus on that outcome — the business needs to be built, managed and driven towards a carefully identified buyer who will pay more. Every decision needs to be targeted at making the business irresistible to a strategic buyer. Many business owners actually lose sight of Stephen Covey’s second habit to, “Begin with the end in mind”, and very quickly get caught up in the day-to-day issues of running a business. These issues do not attract a strategic buyer nor entice them to pay more. Some other common reasons why people make strategic acquisitions are:
› To expand geographically into a new area. (For example, Just Water (NZ) acquisition of Clearwater Filter Systems (Aust)).
› To add a product to their existing loyal client base. (For example, Facebook’s purchase of Instagram).
› To purchase a client base to allow for the sale of other products. (For example, MYOB purchase). › To remove a competitor from the marketplace. (For example, CBA’s purchase of Bankwest). › To leverage an existing business through market branding and position. (For example, Yahoo7’s acquisition of Spreets for $40 million based on fewer than 12 months of trading.) Focus must remain on the outcome. Everything must be done to make the business more attractive and make the value, (with leverage), more and more obvious until a strategic buyer cannot resist the business any longer. 6 • May 2013
Succession and exit planning for business owners Some businesses have gone to considerable lengths to attract a strategic buyer, such as opening an office in another state and focusing on marketing to the potential buyer’s existing clients, or offering preferred pricing to the prospective buyer’s customers. They may focus public relations efforts on product announcements and even make an aggressive effort to recruit key staff form the potential buyer. This is not a quick fix and these sales typically take a lot of preparation and work, but if implemented correctly can yield substantially higher sale prices for the business — which at the end of the day is the reason most SMEs, exist in the first place. For example Social network Facebook bought Instagram — a profitless, two-year-old photo-sharing application — for $US1 billion in April 2012. The huge price tag defied its profitless record. Also incredibly, the app took just eight weeks to build and launch. Instagram is a mobile sensation that counts Twitter co-founder Jack Dorsey among its backers, and has been downloaded by more than 30 million people. The $1 billion price is the highest for a profitless startup since Google bought YouTube for $US1.65 billion in 2006.
Stage Five: Manage value This process focuses on managing the wealth extracted (proceeds of sale, employee share plans, capital raising, mergers, etc) from the business. The proceeds should be used to maxmise the performance of passive income, minimise any risk areas, protect assets and utilise taxation and retirement planning benefits. Also at this stage, including the benefits from a superannuation fund strategy may be important to ensure, (during the move into the wealth management phase), that appropriate structures are used to assist with the transition to retirement.
IN CONCLUSION Business succession and exit planning is about combining the business, financial, and personal goals of the business owners, in order to design and implement an appropriate exit strategy. The basis of a successful succession or exit plan involves a number of steps. It is first necessary to identify the value of the business and then to protect and maximise this value. Next, the built up business value will need to be extracted through sale or other means, with the final stage being to ensure the funds received are used appropriately for investment planning. Business owners must be prepared to make every decision, and consider whether it brings them closer to, or further away from the ultimate exit strategy.
REFERENCES Covey, S (1999), The 7 Habits of Highly Effective People: Powerful Lessons in Personal Change, Simon & Schuster. Smyrnios, K, Romano, C, and Tanewski, G, (1997), Australian Family & Private Business Survey 1997, Monash University, Melbourne. West, C (2013), Business succession and exit planning – learn how to maximise the value of a business on exit, Brochure, Succession Plus, Sydney.
ACKNOWLEDGEMENT & THANKS We wish to thank the following people for their contribution to the article:
› Craig West, CEO, Succession Plus May 2013 • 7
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