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Frank MoyesFrank MoyesLeeds College of Business Leeds College of Business University of ColoradoUniversity of ColoradoBoulder, ColoradoBoulder, Colorado

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This Week’s AgendaThis Week’s Agenda

Harvest strategyHarvest strategy Visitor – Bob GillVisitor – Bob Gill Hand in Feasibility PlanHand in Feasibility Plan FCQ’sFCQ’s

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HarvestingHarvesting

Definition: “Method for achieving terminal after-tax cash Definition: “Method for achieving terminal after-tax cash flows on investment.” Bygraveflows on investment.” Bygrave

You harvest because?You harvest because? Investors require rate of return. For high growth ventures, Investors require rate of return. For high growth ventures,

won’t come from dividends.won’t come from dividends. Entrepreneur wants a new challengeEntrepreneur wants a new challenge Become part of the problemBecome part of the problem ““I can’t stand it any more.”I can’t stand it any more.”

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Lifestyle BusinessLifestyle Business

Perfect life style businessPerfect life style business Independence, autonomy & controlIndependence, autonomy & control Make sufficient income for your requirementsMake sufficient income for your requirements Good at it & enjoyGood at it & enjoy

Quiet desperationQuiet desperation Don’t see an alternativeDon’t see an alternative Marginal incomeMarginal income Not good at it, family destroyed, alcoholicNot good at it, family destroyed, alcoholic

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When Should Entrepreneur Step Aside?When Should Entrepreneur Step Aside?

Do you have the skills to continue? Do you have the skills to continue? When does it stop being exciting and fun?When does it stop being exciting and fun? ExamplesExamples

John Walker of AutoDesk founder return to full time John Walker of AutoDesk founder return to full time programmingprogramming

Steve Jobs of Apple, replaced by John Scully of PepsiCoSteve Jobs of Apple, replaced by John Scully of PepsiCo

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You Are Ready WhenYou Are Ready When

Company generating steady earningsCompany generating steady earnings Company is at a stage where it must make a transitionCompany is at a stage where it must make a transition Your company has value, but is not liquidYour company has value, but is not liquid Becoming cautious - represents your entire net worthBecoming cautious - represents your entire net worth No longer working 80 hours per week (or the thought of No longer working 80 hours per week (or the thought of

continuing is daunting)continuing is daunting) Founding team interests are changingFounding team interests are changing You are becoming boredYou are becoming bored Your family is becoming restlessYour family is becoming restless

Stolze: Start-up

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Harvesting AlternativesHarvesting Alternatives

Increase the free cash flows Increase the free cash flows Management buy-outManagement buy-out Leveraged buy-out Leveraged buy-out Employees – ESOP’sEmployees – ESOP’s Sell entire businessSell entire business Initial public offeringInitial public offering

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Increase Free Cash FlowsIncrease Free Cash Flows

Cash cowCash cow ProsPros

Not necessary to exit the businessNot necessary to exit the business Retain ownershipRetain ownership Don’t need to find buyerDon’t need to find buyer

ConsCons Tax implicationsTax implications Sustainable competitive advantageSustainable competitive advantage Takes timeTakes time

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Management Buy-out (MBO)?Management Buy-out (MBO)?

ProsPros Management understands business & are motivatedManagement understands business & are motivated Founder knows & trusts Founder knows & trusts Management likely to maintain culture & retain employeesManagement likely to maintain culture & retain employees Bankers understand & willing to fund equity and/or debtBankers understand & willing to fund equity and/or debt

ConsCons Management must put up large amounts and/orManagement must put up large amounts and/or Founder willing to accept installment paymentsFounder willing to accept installment payments High amount of debt affects cash flowsHigh amount of debt affects cash flows Risk of defaultRisk of default

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Leveraged Buy-out (Leveraged Buy-out (LBO)?LBO)?

ProsPros Managers from large companies looking to become Managers from large companies looking to become

entrepreneursentrepreneurs Bring experience and new perspectiveBring experience and new perspective Credibility with lendersCredibility with lenders

ConsCons Founder doesn’t know new ownersFounder doesn’t know new owners May not maintain culture and retain employeesMay not maintain culture and retain employees Final payment depends on earn-out (may be required in order Final payment depends on earn-out (may be required in order

to agree on valuation)to agree on valuation)

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Employee Stock Ownership Plan (ESOP) IEmployee Stock Ownership Plan (ESOP) I

Leveraged ESOPLeveraged ESOP ESOP borrows money from a lender to buy owner’s ESOP borrows money from a lender to buy owner’s

stock. Held in trust.stock. Held in trust. Company make tax-deductible contribution to trust to Company make tax-deductible contribution to trust to

repay loan.repay loan. Company guarantees debt of ESOPCompany guarantees debt of ESOP

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ESOP IIESOP II ProsPros

Tax advantagesTax advantages If ESOP owns > 30%, then owner can avoid capital gain tax by If ESOP owns > 30%, then owner can avoid capital gain tax by

purchasing stocks or bonds of another US companypurchasing stocks or bonds of another US company If ESOP owns> 50%, then lender is taxed on only 50% of income; If ESOP owns> 50%, then lender is taxed on only 50% of income;

therefore can offer lower interest rate.therefore can offer lower interest rate. Dividends are tax deductible, i.e. like interest Dividends are tax deductible, i.e. like interest

Employees own share of companyEmployees own share of company Suitable for companies in industries where acquisition is not Suitable for companies in industries where acquisition is not

likely, e.g. constructionlikely, e.g. construction ConsCons

Owner may not want employees to control companyOwner may not want employees to control company Must disclose information such as exec salariesMust disclose information such as exec salaries

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Sale of Entire BusinessSale of Entire Business

Company needs to finance growthCompany needs to finance growth Company at a transitions stageCompany at a transitions stage Founder wantsFounder wants

Diversify investmentDiversify investment Change for personal reasonsChange for personal reasons Another challengeAnother challenge

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Sale Issues ISale Issues I Owners naivetéOwners naiveté

Expectations towards valueExpectations towards value Selling your soulSelling your soul Founder negotiating dealFounder negotiating deal

Deal structureDeal structure ValuationValuation Cash or shares - risk of holding shares Cash or shares - risk of holding shares Lock-up periodLock-up period Tax implicationsTax implications Earn outEarn out

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Earn-Outs IEarn-Outs I

Final purchase price depends on how the company Final purchase price depends on how the company performs in the years subsequent to the purchaseperforms in the years subsequent to the purchase

Buyer:Buyer: Wants company to perform wellWants company to perform well Doesn’t want to buy a cat in a bagDoesn’t want to buy a cat in a bag Management to be motivated to make a successManagement to be motivated to make a success

Seller:Seller: Believes the business is worth moreBelieves the business is worth more Willing to take a risk to increase amount receivesWilling to take a risk to increase amount receives

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Earn-outs IIEarn-outs II

Inherent conflictsInherent conflicts Buyer wants to pay lowest priceBuyer wants to pay lowest price Seller wants to receive highest priceSeller wants to receive highest price

Works when Buyer and Seller interests are alignedWorks when Buyer and Seller interests are aligned Buyer can manipulate earnings to reduce final purchase Buyer can manipulate earnings to reduce final purchase

priceprice Accounting policiesAccounting policies Inter-company transactionsInter-company transactions

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Sale Issues IISale Issues II

Can take a long time (up to 18 months)Can take a long time (up to 18 months) Deal may fall throughDeal may fall through

DevastationDevastation Impact on employeesImpact on employees Loss of momentumLoss of momentum

What do I do now?What do I do now? Continue in management? – become a manager, decision Continue in management? – become a manager, decision

making, culturemaking, culture Sail your boatSail your boat

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Valuing the Company for HarvestValuing the Company for Harvest

Multiple of Multiple of EarningsEarnings

Net IncomeNet Income EBITDAEBITDA

Cash flowCash flow RevenuesRevenues

Net AssetsNet Assets Present Value of Free Cash FlowsPresent Value of Free Cash Flows Importance of intangiblesImportance of intangibles

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IntangiblesIntangibles

Inventory undervaluedInventory undervalued Replacement value of assets is highReplacement value of assets is high Company has been run to minimize income taxesCompany has been run to minimize income taxes

FastTrac

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Carmel Art GalleryCarmel Art Gallery

20 years in business, profitable20 years in business, profitable Established wealthy client and art buyer from all over worldEstablished wealthy client and art buyer from all over world 10 year lease in prime location with heavy traffic10 year lease in prime location with heavy traffic Well trained sales people who understand the customers’ Well trained sales people who understand the customers’

needsneeds Excusive rights to 6 famous local artistsExcusive rights to 6 famous local artists Operating permit – moratorium on art gallery licensesOperating permit – moratorium on art gallery licenses

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How Find a Buyer?How Find a Buyer?

Investors, Board of DirectorsInvestors, Board of Directors Accountants, bankers, attorneysAccountants, bankers, attorneys Investment banker – Lehman formulaInvestment banker – Lehman formula Brokers - fee is based on sale priceBrokers - fee is based on sale price Founder’s industry contactsFounder’s industry contacts Be proactive – identify potential buyers earlyBe proactive – identify potential buyers early

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Preparing Your Company for Sale IPreparing Your Company for Sale IWindow of opportunityWindow of opportunity

Record of growth and profitabilityRecord of growth and profitability LuckLuck

Strong management team & Board of Directors Strong management team & Board of Directors & Advisors& Advisors

Clean ownership structureClean ownership structure Minority shareholdersMinority shareholders

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Preparing Your Company for Sale IIPreparing Your Company for Sale II

Avoid legal hasslesAvoid legal hasslesReady for due diligence processReady for due diligence process

Audited financials by a top firmAudited financials by a top firm Management controls & information systemsManagement controls & information systems

Representations and warrantiesRepresentations and warrantiesWhat tell employees?What tell employees?

Consider Going Public

Choose Underwriter

Prepare Prospectus

Road Show

Pricing Meeting

Consequence

IPO ProcessIPO ProcessCompany Has All the Power

Investment Banker Gains Power

Market & Investment Banker In Control

Market Takes OverTeaching Notes, CML (B) & (C) Harvard College 1985

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Initial Public Offering Cons?Initial Public Offering Cons?

Not suitable for most companies: size, history, Not suitable for most companies: size, history, managementmanagement

Timing is everything – hot issuesTiming is everything – hot issues Difficult for founders to sell shares – lock up periodDifficult for founders to sell shares – lock up period Cost is high: legal fees, underwritersCost is high: legal fees, underwriters

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IPO Cons IIIPO Cons II

Time required from management before, during, and after – 6 Time required from management before, during, and after – 6 to 18 months to 18 months Roadshows Roadshows Underwriters, lawyers, accountantsUnderwriters, lawyers, accountants DisillusionmentDisillusionment

Price of shares may fall below offer price. Market “under Price of shares may fall below offer price. Market “under values”values”

Shareholder suitsShareholder suits Disclosure requirements – SorbaineDisclosure requirements – Sorbaine Pressure for short term profitsPressure for short term profits

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Initial Public Offering Pros?Initial Public Offering Pros?

Pressure for short term profitsPressure for short term profits LiquidityLiquidity Alternative to venture capitalAlternative to venture capital Higher valuationHigher valuation

Flavor of the monthFlavor of the month

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IPO Pros IIIPO Pros II

Company more visibleCompany more visible Easier to hire employeesEasier to hire employees Credibility with bankers, suppliers, customersCredibility with bankers, suppliers, customers

Impact on competition, fundingImpact on competition, funding More fun for top management, if going wellMore fun for top management, if going well If decide to merge with a larger company, will get higher If decide to merge with a larger company, will get higher

valuationvaluation

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Harvesting ConclusionsHarvesting Conclusions

Should plan for harvesting? It may not happen.Should plan for harvesting? It may not happen. Don’t take actions that preclude selling to the highest Don’t take actions that preclude selling to the highest

bidder, e.g. strategic alliancesbidder, e.g. strategic alliances A company with an exit strategy is easier to manageA company with an exit strategy is easier to manage

Motivating forceMotivating force Set high standardsSet high standards Required actions help run the businessRequired actions help run the business