Some exit strategies for family business operations

June 7, 2010
| By Paul Mudde |
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As baby boomers who run family-owned companies reach retirement, a record number of companies will go through ownership and leadership transitions.

Planning for succession to the next generation or exiting the business through a sale of the business requires significant time. The focus of an exit strategy should range from issues involving the emotional or psychological disengagement of the current owner-manager of the family business, the development of the next team of business leaders, and the transition of ownership in the company. All of these issues are inter-related and require time for learning, evaluating options and implementing a successful transition.

Leon Danco, a well-known pioneer family business advisor, noted: “Most owners don’t plan (for exit) because they don’t think they are ever going to retire or die.” Of course, without the owner’s commitment there is no exit strategy. So, why are owners reluctant to plan for exit?

First, a large part of personal identity, especially for men, is tied to work and career success. This is particularly strong for family business owner-leaders, since the boundaries between work and family are blended and the family name and sense of personal identity is often tightly connected to their work and company. Second, their retirement income is dependent on the value of the family business. As owner-managers, income is assured by the continued operation of the company and the pay and profits associated with it. Retiring requires a change in ownership that results in a similar income stream, which involves determining the valuation of the business and plan for a change in ownership. Third, there are concerns about the future of the company without its long-term leader. The next generation of leadership needs to be developed and encouraged to step into greater levels of responsibility.

As noted, the first step in an exit strategy is the current owner-manager taking the psychological step toward exiting their company. Developmental Psychologist Erik Erikson discusses two main stages of adult life: adulthood (age 20 to 50) and late adulthood (age 60 and over) that potentially affect an exit strategy. By the adulthood stage, a person has moved through the developmental stages of childhood and adolescence and the most immediate stage of young adulthood, which focuses on forming an intimate, committed relationship. The adulthood stage is a phase of life that focuses on “generativity” or “stagnation.”

Erikson suggests that in adulthood, we develop our careers, build families and contribute to our communities in order to provide for our children or the next generation. Generativity involves the capacity to master a career, launch and grow a business, share with our children and communities, mentor and develop others in their progression to adulthood. The alternative proposed by Erikson, “stagnation,” means being fixated on oneself, unable to contribute to others and grow successfully into late-adulthood.

Late adulthood offers two possible alternatives: “integrity” or “despair.” Integrity involves accepting the truth about the way one has chosen to live it; despair is the feeling that what I have done has had little value or meaning.

Letting go, or a graceful exit, is dependent on experiences that allow a business leader to have built personal relationships through generative activities, to trust and rely on the competence of others and to accept the imperfections and unfinished business in the family-owned company. It also supports a transition that allows the next generation of leadership to address these challenges in their own way (and with their own imperfections and inadequacies). This also provides the opportunity for the retired business leader to gain additional perspective to see the meaning and value of a life well lived.

The second obstacle in an exit strategy is financial dependency on the family business. The first step in dealing with a change in business ownership is valuing the business. Business valuation is based on a number of techniques, the most common of which depend on determining the expected cash flows and profitability of the company after a change in ownership occurs. In a cash-flow-based valuation, the analyst determines the free cash flows generated by the business and an appropriate discount factor to estimate the value of cash flows that occur in future years. In today’s economic environment, business valuations are depressed due to weaker current cash flows and pessimistic future expectations.

Another technique used for business valuations is based on multiples from comparable business sales. In this approach, the analyst estimates profit before depreciation, taxes, interest and amortization (EBITDA) for the last completed fiscal year and applies a multiple based on recent transactions of businesses with similar size and industry affiliation. Similar to the previous technique for valuation, multiples are lower in the current economic environment, depressing business values. Another technique used in valuations is an asset-based estimate of company value. Based on the liquidation value, this is typically a low estimate of a company’s value.

Valuation should be examined early in the planning of an exit strategy. The current economic environment provides one reason for this: Valuations aren’t stable over time. Many of the factors affecting business valuation are outside the control of owners, such as economic cycles and industry trends, but others can be managed to improve valuations. With planning, a family business owner preparing for a change in ownership can make the company more attractive to a buyer by focusing on improving its management team, its systems and processes, its customer and supplier relationships, and its facilities and equipment.

Regardless of whether the exit strategy plans to transition ownership within the family or to an outside buyer, strengthening these parts of the business will contribute to a higher valuation by contributing to better expected performance after the sale.

As noted, preparing the company for a change in ownership requires preparing for a successful leadership transition. This involves identifying the next generation of both family and non-family leadership. A transition event can often raise uncommunicated expectations in key managers. Non-family management may expect growing responsibilities as part of the transition or may even anticipate some involvement in ownership. It’s important to not disenfranchise key managers, whether family or non-family, as a transition in ownership and control is nearing.

Open communication and training and development plans that groom key managers to take on greater responsibilities will help the exit strategy to progress. The current owner can give up control with confidence. The business valuation is improved due to stability and continuity. And, the new owners and managers can focus their energies on taking the family business to the next level of performance and growth.

Dr. Paul Mudde is director of the Family Owned Business Institute and professor of management, Grand Valley State University.

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