Exit strategy lessons from the frontline
Succession planning is the elephant in the room for many small businesses, where personal and business considerations can become blurred. Articulating a clear, defined plan for exit – with safety nets for all partners – is essential for avoiding future conflict at a management level, as well as potential client and staff issues.
However, while all other elements of business strategy are openly shared and discussed, exit strategy may seem a mystery until an unexpected situation arises. A partner decides they want to retire or pursue a new venture, a talented staff member wants to buy into the business, or a majority shareholder becomes seriously ill.
Macquarie Business Banking often works behind the scenes on partnership and acquisition deals for its clients. Here are some real-world approaches to consider.
Articulating a clear, defined plan for exit... is essential for avoiding future conflict at a management level, as well as potential client and staff issues.
A new structure for younger partners
DCH Legal is an established family law practice in Perth, with almost three decades of trading history. When one of the three partners decided it was time to retire, they realised it would have a significant impact on cash flow and capital investment.
“We had to work the numbers to reconfigure the firm,” explains Toni Parkinson, one of the remaining partners in the business. “There were also two employees we wanted to bring in as partners, but they were not in a financial position to raise that capital themselves.”
Although the firm was in a sound financial position with no major debt, their incumbent bank couldn’t finance the transaction. “We worked with Macquarie to look at our structure in a different way,” she explains. “We needed to inject some capital to pay out the exiting partner, close off the old firm and start a new entity trading under the same name.” The assets were transferred to the new entity, and the two remaining partners put their proceeds back into it. This gave the new business security to establish a revolving loan for the two new partners, who each borrowed to fund their equity.
“Bringing in the next generation of partners is a growing challenge for law firms, because they’re less likely to have built up equity in their own property,” comments Parkinson. “Thinking about different funding models means that’s no longer a barrier to entry.” The whole process took around 12 months, with some help from Deloitte Private Banking and their Macquarie Business Banking Relationship Manager.
“We now have a succession plan in place for the next stage,” Parkinson says. “Knowing you can easily transition is the most important things – whether you choose to do it or not. And we now have the structure in place to allow that to happen.”
The ingredients of a valuation
“Business valuations are based on both quantitative and qualitative data,” explains Danny Chung,National Head of the Built Environment with Macquarie Business Banking.
“Quantitatively, we look at Earnings Before Interest, Tax and Depreciation (EBITD) to estimate what we would reasonably expect profits to be over time – the result is Future Maintainable Earnings (FME). But qualitatively, we then apply a multiple to that amount.”
A range of factors influence the qualitative element of the valuation, including:
- Nature of revenue (and who brings it into the business)
- Barriers of entry to the market
- Customer base
- Quality of earnings
- Evidence of sales
- Staff skills and capabilities
- Macroeconomic factors
- Whether the sale is internal or external
Chung gives the example of a small engineering consultancy with one principal. “He wanted to sell to existing staff, and remain in the business for three more years. The two new shareholders would receive equal equity, but they had limited assets (outside their own home) to use as security for funding to buy into the business.”
Macquarie Business Banking could use the business’ cash flow as security to fund in the new shareholders. The debt was held in their individual names and repaid at an agreed rate.
Alternative funding models
Another way to structure the repayments is to deduct it from the shareholder’s dividends each year.
“Effectively, you could allocate a specific share allotment over a period of time – say 10 per cent at a specific valuation. In lieu of dividends, they would effectively pay down that amount,” explains Chung. You could also bring a junior partner in as a part-equity partner – for example, start at 10 per cent gradually increase this over time until they have full ownership through withholding profit or repayments.
The structure and funding model you choose depends on your preferred exit timing, and the business’ capital requirements. An outgoing partner may not be able to wait for payment.
“It’s important to realise an internal successor does not need their own capital to invest – as this may preclude you from choosing the best candidate,” says Chung. “The security for funding may already be within your business.”
When you start asking questions about your staff turnover and client relationships, you realise what’s really important to your business.
He says it’s also illuminating to go through the process of valuing your business as part of your succession plan. “When you start asking questions about your staff turnover and client relationships, you realise what’s really important to your business. As a result, you may identify new ways to add more value in the short term.”
For Parkinson, it was valuable to know they were better prepared for the transition than they expected. “There was some uncertainty for staff initially, as the successors were internal. And we needed to help the new partners understand their obligations and responsibilities. But now we have a lot more confidence on how we think about the future.”