F & A Advisor: When to exit your firm

By W. Hobson Hogan Principal, Investment Banking ZweigWhite Owners often ask me when is the best time to sell their firms. It’s a common question. The answer that they are seeking typically hinges on valuation and the strength of M&A markets. The fact of the matter is that timing markets is difficult, especially considering that a typical M&A process takes around 12 months to complete, start to finish. You just cannot time the market like freely traded equities because often the economy, interest rates, political climate, etc., are different from when you entered the market. Sometimes the overall picture is better, sometimes it is worse. If I knew with any certainty the direction of financial markets, I would be writing this article from my Gulfstream V. The question of when to sell your firm is more about desire of the ownership of your firm to cash in their shares and the makeup of the senior leadership. In my last article, “Are You Irreplaceable?” (The Zweig Letter, August 22, issue 924) I raised the concept of maximizing shareholder value by maximizing yearly distributions to shareholders, rather than maximizing shareholder value through a sale. If your firm is made up of highly productive senior people whom you are unlikely to replace, then waiting for a big premium in a firm sale is a suspect strategy. It is better to run the firm in a way to maximize the returns to the shareholders and toss someone the keys when you are ready to hang up your spurs. Helping firms with owners in their late 50s or early 60s make a decision is often straightforward; the more nuanced problem is when you have a firm with a younger leadership team with time to make a decision as to which strategy to undertake – maximize value through a sale or through distributions. Firms with younger owners essentially have three choices: 1) Organize the firm to maximize the yearly distributions and sell for a lower premium at the end of their careers; 2) Find and groom future leaders to run the firm after a future sale; or 3) Sell today when a buyer can still enjoy the benefits of the current leaders’ work. In this tough market, the knee-jerk reaction is to dismiss the third choice due to depressed multiples. While it is certain that in some point in the next 10 years, the market for A/E/P firms will be stronger than it is today, there is no certainty that this strength will translate into a better market for any single firm. Let’s look at an example – XYZ & Associates, which had $1 million in EBITDA in 2010. It is very possible that XYZ may sell today for $5 million (a multiple of 5.0x EBITDA). Let’s suppose the firm decides to wait five years and, due to an aging leadership, the multiple for that firm dropped to 4.0x EBITDA. If EBITDA did not increase to $1.25 million, XYZ would have been better off to sell today. This is an overly simplified example because I did not take into account the return on capital the owners could have achieved from a well diversified investment portfolio. Look at the example with a 7 percent annual investment return layered in. The sale today would yield a net value of $4.3 million assuming capital gains taxes at 15 percent. With $4.3 million compounded annually at 7 percent, the owners of XYZ would have $6 million in five years, assuming no distributions. In order for the owners of XYZ to be ambivalent between a sale today or tomorrow, then the EBITDA of XYZ would have to increase from $1 million today to $1.8 million in five years. Considering the difficulty of the market, this is a tough task. I am sure you are thinking that dropping the multiple a full turn is too harsh; however, even if the multiple stays the same (5.0x), XYZ will need to grow earnings to $1.4 million. There is also one assumption that I held constant that may or may not be the same – capital gains taxes. While I cannot say whether they will be higher, I can say with some certainty that they will not be any lower than they are today. If the multiples are the same today as in five years and capital gains rates increase to 28 percent (as they were during the Clinton years), then EBITDA would have to increase to $1.7 million in five years. When I was a teenager, I accompanied my father on a business trip to Houston. We were driving to a friend’s house in River Oaks, a very nice neighborhood in town. He was grumbling about how well a real estate investor had done with a warehouse property he had sold to them. I, being an all-knowing teenager, said, “Dad, why did you sell it? You should have held on to it.” His response was simple, “Son, do you see all these nice houses? Well they are filled with people that sold too early.” I asked, “Well, where do the people that sold too late live?” He simply said, “Somewhere across the tracks, son.”

Owners often ask me when is the best time to sell their firms. It’s a common question. The answer that they are seeking typically hinges on valuation and the strength of M&A markets. The fact of the matter is that timing markets is difficult, especially considering that a typical M&A process takes around 12 months to complete, start to finish. You just cannot time the market like freely traded equities because often the economy, interest rates, political climate, etc., are different from when you entered the market. Sometimes the overall picture is better, sometimes it is worse. If I knew with any certainty the direction of financial markets, I would be writing this article from my Gulfstream V.

The question of when to sell your firm is more about desire of the ownership of your firm to cash in their shares and the makeup of the senior leadership. In my last article, “Are You Irreplaceable?” (The Zweig Letter, August 22, issue 924) I raised the concept of maximizing shareholder value by maximizing yearly distributions to shareholders, rather than maximizing shareholder value through a sale. If your firm is made up of highly productive senior people whom you are unlikely to replace, then waiting for a big premium in a firm sale is a suspect strategy. It is better to run the firm in a way to maximize the returns to the shareholders and toss someone the keys when you are ready to hang up your spurs. Helping firms with owners in their late 50s or early 60s make a decision is often straightforward; the more nuanced problem is when you have a firm with a younger leadership team with time to make a decision as to which strategy to undertake – maximize value through a sale or through distributions.

Firms with younger owners essentially have three choices: 1) Organize the firm to maximize the yearly distributions and sell for a lower premium at the end of their careers; 2) Find and groom future leaders to run the firm after a future sale; or 3) Sell today when a buyer can still enjoy the benefits of the current leaders’ work. In this tough market, the knee-jerk reaction is to dismiss the third choice due to depressed multiples. While it is certain that in some point in the next 10 years, the market for A/E/P firms will be stronger than it is today, there is no certainty that this strength will translate into a better market for any single firm.

Let’s look at an example – XYZ & Associates, which had $1 million in EBITDA in 2010. It is very possible that XYZ may sell today for $5 million (a multiple of 5.0x EBITDA). Let’s suppose the firm decides to wait five years and, due to an aging leadership, the multiple for that firm dropped to 4.0x EBITDA. If EBITDA did not increase to $1.25 million, XYZ would have been better off to sell today. This is an overly simplified example because I did not take into account the return on capital the owners could have achieved from a well diversified investment portfolio. Look at the example with a 7 percent annual investment return layered in.

The sale today would yield a net value of $4.3 million assuming capital gains taxes at 15 percent. With $4.3 million compounded annually at 7 percent, the owners of XYZ would have $6 million in five years, assuming no distributions. In order for the owners of XYZ to be ambivalent between a sale today or tomorrow, then the EBITDA of XYZ would have to increase from $1 million today to $1.8 million in five years. Considering the difficulty of the market, this is a tough task. I am sure you are thinking that dropping the multiple a full turn is too harsh; however, even if the multiple stays the same (5.0x), XYZ will need to grow earnings to $1.4 million.

There is also one assumption that I held constant that may or may not be the same – capital gains taxes. While I cannot say whether they will be higher, I can say with some certainty that they will not be any lower than they are today. If the multiples are the same today as in five years and capital gains rates increase to 28 percent (as they were during the Clinton years), then EBITDA would have to increase to $1.7 million in five years.

When I was a teenager, I accompanied my father on a business trip to Houston. We were driving to a friend’s house in River Oaks, a very nice neighborhood in town. He was grumbling about how well a real estate investor had done with a warehouse property he had sold to them. I, being an all-knowing teenager, said, “Dad, why did you sell it? You should have held on to it.” His response was simple, “Son, do you see all these nice houses? Well they are filled with people that sold too early.” I asked, “Well, where do the people that sold too late live?” He simply said, “Somewhere across the tracks, son.”