How to Determine the Right Strategy When Exiting Your Family-Owned Business
Could this be a good time to sell? Managing Director Tom McNulty highlights the current economic trends, options available for owners when pursuing an exit transaction, and elements needed for success.
Most family-owned businesses will at some point seek to transfer ownership. Now, with a significant percentage of the US population at or approaching retirement age, these discussions are happening more frequently. For a family-owned business, when is the right time for a sale? While personal circumstances may play a large part in this timing, there are currently some key economic indicators that we believe make the immediate future an ideal time to pursue an exit transaction.
Economic factors impacting sell-side engagements
We believe that the US Federal Reserve Bank — the Fed — will continue to raise interest rates. This will likely take us to a level of at least 5.0% next year. This puts pressure writ large on the economy and boosts the cost of capital for anyone seeking to acquire businesses. There is broad consensus that a mild recession will commence in the second quarter of 2023. Spending capacity in the US will be impacted by higher interest rates and inflation, which will cause valuations for private companies to decline.
Compounding these issues is the fact that talk of a recession can lead to recession-like conditions, putting additional downward pressure on valuations. Public valuations rose over many years until early this year when declines set in. Private company valuations had also been on the multi-year rise, but they began to flatten in the third quarter of 2022. This suggests that we could see a decline in private company valuations in the near term. Now is the time to take advantage of this plateau and consider selling in Q1 of 2023 before any further uncertainty begins to take its toll on valuations.
Options for exit transactions
Should an owner decide to pursue an exit transaction, there are generally two paths forward: a straight sale or a recapitalization. With a sale, a controlling interest of up to 100% of the business is sold off to a buyer. This generally occurs when the existing owners of the business have not found someone to take over the business when it comes time to retire, so the business is instead sold in its entirety. Alternatively, the existing owner may want to retain a minority position or may be encouraged by the purchaser to retain some interest, especially if the pre-sale owners will continue in management positions. Many buyers, especially private equity buyers, may prefer this continuing participation. With a recapitalization, someone else within the company takes over — like a child taking over for a parent — but capital must first be raised to buy out the existing owners’ interests.
Navigating the sales process
For family-owned businesses, working with an attorney to do estate and gift taxation planning should trigger the need for an independent appraisal or valuation of the business. The IRS will rarely accept the business owner’s estimate of value, and absent an actual third party transaction, independence is essential. The standard of value for this, Fair Market Value, has to comply with several IRS rules that can be very technical.
With a valuation secured, the business must then be set up to look its best for potential investors. The person preparing the documents — whether that’s a team working at an investment bank or persons internal to the company — will explore the company’s existing financials and complete financial models. The materials should be complete and convincing so as to create the greatest amount of interest among buyers. Based on this information, they’ll create pitchbooks and 1 — 2‑page teasers for investors to review. When done correctly, these deliverables will position the business as an attractive investment to the right set of buyers and maximize value. During this process, a data room is created and maintained, as well as a confidential information memorandum (CIM) for buyers to review after they sign.
Next, the business will be marketed to buyers. The team in charge of the transaction will seek out a pool of buyers; should an investment bank be used, the sale will be marketed to an especially broad network of investors that have already been vetted. A key element is marketing concurrently to a targeted but broad audience in order to create competitive offers for the business. The list of potential buyers will then be refined until only the most serious investors are left to bid.
Finally, once the buyers have bid for the business, the most attractive offer is selected and then due diligence is performed. A purchase agreement will be drafted, and working capital negotiated. The selected buyer or investor will get exclusivity for a set period of time to allow the seller or seller’s representative time to verify the opportunity and get paperwork drawn up. It is often the case that the owner will be asked to stay on for a specified time period to ensure a successful transition.
In the case of a recapitalization, a valuation often must be conducted. For family-owned businesses, this step is usually triggered when the business owner begins working with a lawyer to complete estate or gift planning. Should the business owner want to hand a certain number of shares of the company to their grandchild, those shares must first be priced for tax purposes. The standard of value, which is “Fair Market Value”, has to comply with several IRS rules that can be very technical. An independent appraisal or valuation determines the value of each share, and upon learning that value, some business owners choose to move forward with a sale.
Why partner with an investment bank
For business owners, the sales process represents a substantial effort and time spent away from core business functions — and an additional stress when retirement and internal transition planning are top of mind. From valuations to financial models and investment presentations to buyer marketing and due diligence prior to the transaction, the average family business sell-side engagement requires 1,000 hours of labor to complete. An investment bank like Chiron handles the entire process and removes that time-consuming and labor-intensive work from the company’s list of responsibilities.
Plus, with professionals completing the sell-side engagement, family businesses can achieve better valuations, better sale terms, and a smoother transaction process. Investment banks like Chiron are staffed by former CEOs and executives with deep industry expertise, enabling us to further position a company for a successful sale based on knowledge of the industry and its outlook.
Finally, few family-owned businesses have a ready network of investors, know what all those investors are looking for, or are prepared to manage a process that may involve contacting hundreds of buyers simultaneously in an effort to maximize realized value. Investment banks have a vast pool of promising buyers — and they know what to say and what information to provide to create the kind of bidding war that results in the most value for their clients.