How to work towards a profitable exit
The peculiarities of our laws present major challenges to owners of small to medium sized businesses (SMEs) wanting to sell them. Can profitable exits be engineered?
We have helped many of our clients carry out a profitable business exit. Here are some of the issues that have arisen from time to time.
THE PROBLEM - PERSONAL GOODWILL
It is difficult to put a goodwill factor on a referral network which is built around a person rather than a brand. This is one of the major difficulties for any SME, particularly when the SME provides services (as compared to goods).
Merging an SME can work, but if the prospective vendor is essentially a “one man band” then we advise against anticipating a windfall. The personal nature of many SMEs makes it very difficult to sell.
Any merger of an SME will see a sole owner walk out with all of his or her contacts unless there’s an agreement that says something to the contrary. If the rainmaker of the SME is getting and keeping the clients because he/she has a range of referrers who are happy to continue referring to him/her, how do you move that to the new business? Even with transition arrangements in place, it can be very difficult particularly where many referral bases have aged with the vendor.
There are particular complexities that accompany the departure from the former SME of an employee who is as qualified as the owner/rainmaker.
Quoting from one of our client's senior employees (with their consent): ‘You get employed by an SME and sign an employment contract, but then I brought about 120 good clients to the business through my contacts and referral sources,’ he said.
‘I got these from my own effort and not the business or its name. They should be accounted for in my compensation and entitlement arrangements upon my departure.'
‘I’m a shareholder of the business that I am leaving so that also has to be worked out,’ he said at the time.
THE SOLUTION FOR SUCCESSFUL EXITS
The issue of personal goodwill is a challenge for anyone who is the sole owner of an SME, or who only has 1 or 2 other co-owners. However, there are a number of options available. One is a sale to a senior employee or to several of them. Another is a merger.
But timing is very important and the time frame will impact on strategies and options available. Generally the longer the SME operator has thought about the issue, the better the exit works.
Five years is generally the minimum timeframe necessary for an SME to successfully implement a succession plan. Personal goodwill can usually be realised if such a timeframe is applied.
Many successful SME operators see the benefit of recruiting a senior employee who has the skills to lead the business and a desire to become an owner of it.
They also recruit some talent underneath the senior employee to give them options in the event that the senior employee does not work out for any reason.
The best succession plans include arrangements for that senior employee. The plan should help develop their capabilities and transition the goodwill to that person over time.
THEIR TRANSITION DOCUMENT
Critical to the success of the desired outcome is the clear exposition of milestones to be achieved along the way. Moreover, the best plans transition not only contacts but also referral networks and they include restrictive covenants.
The restrictive covenants acknowledge that transitioning personal goodwill is a risk and the SME must be able to protect its income in the event of a fallout. The client base and the staff must be protected at all costs.
A 12 month restraint preventing the senior employee from canvassing or acting for clients out of the business is a "must have" provision.
What if the senior employee turns out to be a bad leader? This is one of the many reasons why the succession agreement must be reduced to writing and provide for the arrangement to be terminated by either party on the occurrence of nominated trigger events. The succession provisions should be able to be cancelled without necessarily having to terminate the senior employee's employment.
Many of our clients have found that the merger of their business has borne fruit on many fronts. They enjoyed an enhanced quality in terms of their own business life and that of their staff.
They have said that they get much more out of life in a larger partnership or company. They enjoy the economies of scale. Merging an SME with another business gives many more options than those available to the vendor SME on its own.
Adding the merger option to a succession plan is not difficult. Time is the key consideration and five years appears to be the minimum period one needs to successfully implement a merger.
That gives time to look for a business with similar values and culture and that creates an opportunity for both the vendor and the purchaser.
GETTING READY FOR SALE
Preparing for sale or merger is a process. The vendor's profitability, its staff and its management need to present well.
And transitioning the personal goodwill is key. If the revenue streams cannot be transferred then there’s nothing there to buy. We have never seen an SME effect a successful sale without proper legal contracts binding purchasers to legally enforceable obligations.
There is just no way you can value a revenue stream which is dependent on personal goodwill and the vendor "doing the right thing". In this regard, many clients confuse the concept of "trust" with the concept of "communication". Trust is the foundation of any business dealing, but a fully vetted contract prepared by a lawyer will communicate all aspects of the transaction. All bases will (or should) be accounted for. From the transparency that such a document brings, comes confidence and the document thereby enhances the relationship between the parties.
The legal contract should provide a clear pathway to transition referral relationships and personal goodwill to the purchaser.
Looked at this way, a vendor does have something to sell. Many vendors can identify where the market is and tailor their assets to appeal to that market.
Where an SME merges with another business, the feedback we receive is that where a plan is in place to transition the goodwill, most of it does end up going over.
Shared ethics and values are critical to a successful merger or sale. Nevertheless, finding a successor interested in, equipped for and willing to take on the role in an established business is challenging.
PERSONAL EQUITY VERSUS BRAND EQUITY
One of our clients is a business broker and has been involved in many transactions. He says that outdated approaches to selling can cause some businesses to be difficult to sell.
The traditional approach is one dimensional. A business whose goodwill is derived from personal equity is much harder than if it is based on the brand.
Brand equity is typically grounded in established businesses which have some history behind them. Brand equity also is more likely to reside in the business’s name if it didn’t include the names of the principals or founders.
Creative ways to structure the succession include a three-to-five year earn out period. Whilst this can be nerve wracking and unpalatable for the vendor, if structured correctly, it can provide much more to the vendor than a short-term transaction can provide.
The clients whose succession plans work the best are those who work out who are their logical, interested buyers and then get their plan together, prepare an information memorandum and their pitch, and then action the plan.
Leigh Adams is an Accredited Specialist in Business Law and he has a particular focus in Business Succession and Sales. Call him for assistance today on 02 9549 0755 or email LWA@owenhodge.com.au.
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On 1 November 2016, Leigh Adams Business Lawyers merged with Owen Hodge Lawyers at Level 3, 171 Clarence St Sydney
Leigh and his team will be consulting as usual and remain available for appointments in North Sydney.
If you have any questions, then feel free to contact Leigh on 9570 7844 or 9964 0022.