Litigation + Valuation Perspectives

Demystifying Valuation, Economic Damages + Forensic Accounting

8 Essential Elements of an Exit Strategy for Business Owners: Part III

Develop a Strong Management Team

The development of a strong management team is usually a necessary consideration in the preparation of an exit strategy. This helps to ensure a smooth transition with some continuity of leadership and talent. One consideration is whether, and when, the owner replaces himself/herself as the CEO. An outside person may bring a new vision for the company and be better able to take the business to the next level.

 

Existing employees may also be able to step up to the opportunity to assume a greater leadership role. This could include family members that are working in the business as well as unrelated employees. However, if no family members are capable, or willing, to assume greater responsibility, the owner may have to seek outside talent.

 

The establishment of strong internal controls, management systems and accounting systems is also important. Therefore, depending on the size of the business, an owner should also consider hiring a qualified financial professional if one is not already in place.

 

Avoid Over-Reliance on Normalizing Adjustments

 

Sellers should avoid over-reliance on normalizing entries (or normalizing adjustments) to increase the value of their business. Normalizing entries are commonly used in business valuation to adjust the historical financial statements to economic reality. They are several types of adjustments including:  removal of non-recurring income and expenses; removal of owner discretionary expenses like country club dues and personal expenses; removal of income and expenses on assets that have no relationship to the business operations (such as a company yacht); changes in accounting principles from one period to the next; changes to conform to generally accepted accounting principles; and, adjustment of transactions between the owner and the company to the amount at which an independent third party would transact business. Examples of the latter include owner compensation and rent on the owner’s building.

 

Buyers can understand normalizing entries for most of the above adjustments and will acknowledge the validity of those adjustments in determining a purchase price. This is particularly true for adjustments unrelated to removal of personal expenses.  However, buyers tend to determine a purchase price for a business based on actual financial information as presented in the seller’s tax returns, internal financial statements and audited financial statements, when available. They often completely dismiss normalized financial statements that seller’s present regarding the removal of personal expenses.

 

It is difficult for a seller to rationalize certain normalizing entries to a buyer for significant amounts of personal expenses for two reasons. First, they can be difficult to adequately document to the buyer. Second, a federal tax return was filed that likely includes an income tax deduction for the items in question. The credibility of the seller can come into question as a result. The result could be a lower offer price for the business or the buyer walking from the deal. 

 

Have Written Strategic Planning Documents

Though a potential buyer is generally buying the assets of the business, they are also buying the future earning potential of the assets and want to know the expected rate of return on their investment.  The future benefits are usually the most important value driver for most businesses. Therefore, buyers like to see well established budgets with goals and objectives as to how the company is planning to achieve their future results.  Buyers want to know that a seller has a well established “road map” for the company and its employees.

 

When the owner has a well defined process for tracking progress, such as budget versus actual income statements, multi-year cash flow forecasts and ratio analysis related to the company, others can quickly gain an understanding of company historical and forecasted cash flows. It also represents an indication of a well-managed business and it can assist family members and potential buyers to understand the business.

 

Proper strategic planning also helps the management of the company to be able to talk with a potential buyer and others in relationship to the future activities and the earnings potential of the business.

 

Conclusion

 

Okay, so it’s ten essential elements (but who is counting?).

 

Transition planning is very important to an owner’s ability to maximize value when it is time to step away from the business. This is going to occur whether or not a transition plan exists. Better to preserve and maximize value than to leave it to chance.

 

Stephen E. Koons, CPA, ABV, CFF, ASA and Daniel R. Silburg, CPA, CVA