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Exit Planning for Privately Held Businesses – Tradition or Monetary Value? May 12, 2006 Exit Planning for Privately Held Businesses – Tradition or Monetary Value? May 12, 2006 Estate & Business Planning Program By Bill Eastwood Doering, van den Heever & Eastwood Ltd Offices in Fort Collins and Greeley, Colorado Tel (970) 346 -3950

Outline of Exit Planning Alternatives 1. 2. 3. 4. 5. 6. 7. 8. Owner’s Outline of Exit Planning Alternatives 1. 2. 3. 4. 5. 6. 7. 8. Owner’s Alternatives Outside World Case Studies What is Value? Analysis of Alternatives Overview of the Current M&A Market Preparing a Business for Sale Marketing the Business 2

The Owner’s Alternatives l l Family succession Sell the business to management team l The Owner’s Alternatives l l Family succession Sell the business to management team l l Leveraged buyout ESOP Merge the business with a competitor and retain equity Sell to a third party l Strategic buyer – in the business – regional bank buys a community bank 3

The Owner’s Alternatives l l l Sell to a financial buyer – private equity The Owner’s Alternatives l l l Sell to a financial buyer – private equity (leveraged buyout), unparalleled funds available Sale of less than 100% - recapitalization Initial public offering for larger businesses – Cabela’s 4

The Outside World l l l l Global economy “Walmartization” Scarcity of oil and The Outside World l l l l Global economy “Walmartization” Scarcity of oil and basic resources Growth of developing countries General economic prosperity U. S. service based economy Sustained real estate inflation 5

The Outside World l Private equity and hedge funds with $100’s of billions to The Outside World l Private equity and hedge funds with $100’s of billions to leverage and invest in middle market businesses 6

Making Correct Exit Decisions l l When is the correct time to develop an Making Correct Exit Decisions l l When is the correct time to develop an exit plan? Which of the exit alternatives are feasible for the business? Do I need an advisor team? What is my business worth? 7

Making Correct Exit Decisions l l l Does continued family ownership make sense? What Making Correct Exit Decisions l l l Does continued family ownership make sense? What value can I obtain by selling to management? What type of third party buyers would be interested in my business? 8

Case Study #1 – Cattle Rancher Whose Land Became Valuable l l Note: All Case Study #1 – Cattle Rancher Whose Land Became Valuable l l Note: All case studies are fictitious. In each case, the owners are your clients. They have asked your advice. Joe Helerick sat back in his chair on his 20, 000 acre ranch in Sand Hill country, Nebraska reflecting on an offer to buy his ranch. 9

Case Study #1 – Cattle Rancher l l l He was the 4 th Case Study #1 – Cattle Rancher l l l He was the 4 th generation family of a family who had owned and run a successful cow/calf operation. There had been a number of difficult times but he now had 400 mother cows and had been able to make a good living. The ranch had paid to educate his two children, Jack, age 34, a lawyer in Houston, and Jessica, a dentist in Lincoln, NE. 10

Case Study #1– Cattle Rancher l l Joe’s wife, Sandra, was tired of looking Case Study #1– Cattle Rancher l l Joe’s wife, Sandra, was tired of looking after the cattle, particularly during cold winter stretches like the one they were presently experiencing. The Helericks did have a condominium in Lincoln and had a time share in Hawaii to enable them to get away. 11

Case Study #1– Cattle Rancher l l Running through the ranch was a “gold Case Study #1– Cattle Rancher l l Running through the ranch was a “gold medal” fishing stream where the Helericks had been able to supplement their income through fishing leases that now amounted to $50, 000+ per year. The offer for the ranch was $21 million by a group of West coast real estate developers who wanted to build a golf course. 12

Case Study #1 – Cattle Rancher l l l Joe had many offers before, Case Study #1 – Cattle Rancher l l l Joe had many offers before, but never one this tempting. Although in good health at age 63, Joe knew that sometime in the future he would have to decide what to do with the ranch. Both Jessica and Jack wanted him to keep the ranch, but had no interest in returning or assisting in the maintenance. 13

Case Study #2 – The Impressive Software Co. l l Jack Calvert of Lincoln, Case Study #2 – The Impressive Software Co. l l Jack Calvert of Lincoln, Nebraska, had a critical decision to make. At age 70, he had to decide what to do with his computer software company that made specialized software for the oil and gas industry. The company had been very successful and Chuck Mac. Intire, age 49, had managed the business for a number of years without any real day-to-day management assistance from Jack. 14

Case Study #2 – Software Co. l l l Jack had been instrumental in Case Study #2 – Software Co. l l l Jack had been instrumental in helping make several add-on acquisitions. Sales of $11 million generated $2. 7 million of EBITDA for 2005. Jack had received numerous offers over the years to buy the business. 15

Case Study #2 – Software Co. l l He had received numerous calls from Case Study #2 – Software Co. l l He had received numerous calls from investment bankers telling him of the advantages of selling to the employees with a private equity group owning a large part of the business and the management owning a minority stake. Other investment bankers had wanted to have an auction to sell the property to the absolutely the highest bidder without any consideration for the 40 employees, many of whom had worked at the business for many years. 16

Case Study #2 – Software Co. l Jack now spent 3 -4 months of Case Study #2 – Software Co. l Jack now spent 3 -4 months of the year hunting and fishing with a little golf in between his home in Hawaii, his condo in Cabo San Lucas, and an elegant home in Lincoln, Nebraska. 17

Case Study #2 – Software Co. l l Neither of his children, Jill nor Case Study #2 – Software Co. l l Neither of his children, Jill nor Bill, were interested in the software business and were well taken care of from his estate through other means. Jack was an avid University of Nebraska football fan and had attended every game for the last 7 years (even in 2004). 18

Case Study #2 – Software Co. l l Jack talked to an investment banker Case Study #2 – Software Co. l l Jack talked to an investment banker friend of his regarding valuation of the company. The banker placed a preliminary valuation of $17 -22 million on the business that had been growing 8 -10% annually. 19

Case Study #2 – Software Co. l l l Jack sat down with the Case Study #2 – Software Co. l l l Jack sat down with the key management people at the company. He asked them if they were interested in buying the business. They said that they were very interested in buying the business. He also broached the idea of a private equity firm taking most of the risk and management owning a minority position. 20

Case Study #2 – Software Co. l Jack also discussed the opportunity to sell Case Study #2 – Software Co. l Jack also discussed the opportunity to sell to a large software company where the best programmers would have opportunities outside his company. 21

Case Study #3 – The Wishful 3 rd Generation Community Grocery Store Owner l Case Study #3 – The Wishful 3 rd Generation Community Grocery Store Owner l l l Rick Hayworth, age 67, was a third generation independent grocery store owner in Crete, Nebraska. He had operated the business for 25 years and was in good health. Two years ago he had turned the day-to-day operations of the business over to his son George. 22

Case Study #3 – Grocery Store Owner l l l George, age 44, had Case Study #3 – Grocery Store Owner l l l George, age 44, had two ambitious sons who also worked in the business. They had recently moved their store to a new 25, 000 sq. ft. modern grocery store with deli, bakery, pharmacy, “all the things that bigger stores had. ” His store was supplied by a national food cooperative to keep the business competitive. 23

Case Study #3 – Grocery Store Owner l l Rick was evaluating an offer Case Study #3 – Grocery Store Owner l l Rick was evaluating an offer he had recently received from Safeway, a national grocery chain. Because Crete was a fast growing community and the wishful grocery store met its specifications, Safeway wanted to have a good footprint in the location (population now 7, 000) without having to compete head to head with the community grocery store. 24

Case Study #3 – Grocery Store Owner l Hayworth was also contemplating an offer Case Study #3 – Grocery Store Owner l Hayworth was also contemplating an offer to buy two other independent grocery stores in adjoining towns, that were being sold by another independent grocer who was retiring, for George’s sons to manage. 25

Case Study #4 – The CNC Machine Company Co. l l Dave Mac. Intosh Case Study #4 – The CNC Machine Company Co. l l Dave Mac. Intosh and his two brothers, Tom and Mike, were contemplating what to do with their business. The business had grown to almost $20 million in annual sales with profits exceeding $5 million per year. 26

Case Study #4 – CNC Co. l l They made medical components, triggers for Case Study #4 – CNC Co. l l They made medical components, triggers for air bags, computer disc drives, defense contractor parts and other specialty components. The Computer Numeric Control Machines (“CNC”) (patterned on Swiss watch technology) were one of the fastest growing manufacturing machines in the world. 27

Case Study #4 – CNC Co. l l Because the machine could make up Case Study #4 – CNC Co. l l Because the machine could make up to 50 different cuts on one component (none larger than your hand). Once the machine was configured, it was reliable and could run lights out 24/7. 28

Case Study #4 – CNC Co. l l Dave, at age 44, knew that Case Study #4 – CNC Co. l l Dave, at age 44, knew that the market was excellent for his business. An investment banking firm had advised them that they should explore exiting the business due to increased threat of foreign competition. 29

Case Study #4 – CNC Co. l l Their mother, age 66, owned one-fourth Case Study #4 – CNC Co. l l Their mother, age 66, owned one-fourth of the company. She had kept the company and the family together during very difficult times when their father had died 15 years ago at the age of 49. 30

Case Study #5 – The Case of the Successful Cabinet Maker Who Waited Too Case Study #5 – The Case of the Successful Cabinet Maker Who Waited Too Long l l Joe Seamster had been very successful making customized cabinets for regional home and commercial builders. His operation was efficient enough to sell quantities to the large box stores (Lowes, Home Depot) to keep his production lines moving smoothly during the slow periods even though his margins were much less. 31

Case Study #5 – Cabinet Maker l l Joe, at age 65, had completed Case Study #5 – Cabinet Maker l l Joe, at age 65, had completed a major plant expansion to take care of the booming real estate market in Lincoln in 2005. The company had spent $3. 5 million ($2. 5 million financed by an industrial revenue bond) and had also added over another $1. 0 million in equipment. 32

Case Study #5 – Cabinet Maker l l The business currently made about $2. Case Study #5 – Cabinet Maker l l The business currently made about $2. 0 million a year on sales of 18 million. Twelve months ago, Joe, a heavy smoker, found out that he had lung cancer. He had fought valiantly. Recently he was informed that he had less than 3 months to live. 33

Case Study #5 – Cabinet Maker l l l Joe had an excellent general Case Study #5 – Cabinet Maker l l l Joe had an excellent general manager who was capable of running the business. His wife, Josephine, knew nothing about business and was totally reliant upon all of Joe’s decisions. Their two children, Steve and Dick, were both trying to find their way in life and lived in Boulder, CO. To date they had shown no interest in the business. 34

What is Value? l l Value is measured differently by each buyer or owner What is Value? l l Value is measured differently by each buyer or owner Not all value = $ l Social, Ethical, Moral, Religious, Sentimental, Economic and Commercial Value l l l Emotion Legacy People factor 35

What is Value? l Going Concern Value l Fair Market Value = $$$$ l What is Value? l Going Concern Value l Fair Market Value = $$$$ l l l Capitalization of Earnings Discounted Cash Flows Market Approach 36

Family Succession l l Often emotional attachment to business Usually owner carries note Not Family Succession l l Often emotional attachment to business Usually owner carries note Not usually the best way to maximize financial value Usually results in ongoing risk to seller 37

Family Succession l Hard questions l l l Does the next generation have the Family Succession l Hard questions l l l Does the next generation have the ability and desire (passion) to successfully manage? Can the business compete effectively in present environment? Need to grow Need to sell to a larger strategic competitor or orderly liquidation Need to diversify 38

ESOP (Employee Stock Ownership Plan) l l Enables employees to acquire beneficial ownership in ESOP (Employee Stock Ownership Plan) l l Enables employees to acquire beneficial ownership in their Company without having to invest their own money Advantage of the ESOP is that employees are able to acquire this stock without paying a current income tax on the stock The advantage to the Company is that the ESOP makes pre-tax dollars available to finance Company growth and/or to create ownership liquidity at the time of retirement Owner has tax advantages on sale proceeds 39

Recaps & Mergers l Management leveraged buyout l l l Feasibility and cash flow Recaps & Mergers l Management leveraged buyout l l l Feasibility and cash flow business Partial sale or recapitalization? l Sale of majority or minority stake l Leverage the business l Risk of ongoing ownership l New partners Merger l Usually paid in stock of merged entity l Liquidity event dependant on future success of merged entity 40

Outright Sale l l l Individual (small deals < $3 million) Strategic/synergistic buyer (all Outright Sale l l l Individual (small deals < $3 million) Strategic/synergistic buyer (all sizes) Financial buyer > $3 million or larger 41

Robust M&A Market 42 Robust M&A Market 42

Robust M&A Market 43 Robust M&A Market 43

2005 Value Multiples All Manufacturing Companies by Revenue (North America) Annual Revenue Medium Multiple 2005 Value Multiples All Manufacturing Companies by Revenue (North America) Annual Revenue Medium Multiple (EBITDA) $ 50 Million - $200 Million 8. 2 $20 - $50 Million 6. 8 $10 - $20 Million 6. 4 Under $10 Million 5. 4 Source: IMAP 2005 Pricing Survey Results. IMAP members around the world advised on 220 transactions with $4. 079 billion in valuations. 44

Structure of the Deal Affects Value l Currency l l Cash is king Seller Structure of the Deal Affects Value l Currency l l Cash is king Seller financing brings higher price l Particularly on deals valued under $25 million Stock swap — tax deferral and liquidity consideration, negative stock market risks Stock or asset sale 45

Value of Privately Owned Businesses l Factors that differentiate an 8 x+ multiple business Value of Privately Owned Businesses l Factors that differentiate an 8 x+ multiple business from a 3 x (an “A” business from a “C” business): l l l l Industry (growth vs. stagnant) Size (Scalability) Growth in sales (speed to acquire opportunity) Earnings — growth, quality and consistency Balance sheet strength Perceived competitive advantage — brands, patents, technology, costs Margin as percent of sales Strength and continuity of management 46

Value of Privately Owned Businesses l Exceptions to the 3 to 8 EBIT rule: Value of Privately Owned Businesses l Exceptions to the 3 to 8 EBIT rule: l l l Each buyer will have a different criteria for valuation Some buyers and industries use EBITDA rather than EBIT Examples: l l l Private equity firms evaluate based on projected ROE Food brand purchaser may project savings in costs from adding a brand to its existing distribution system Cable company businesses sold on a value per subscriber 47

Who Are The Buyers? Strategic / Synergistic Buyers l A buyer in the same Who Are The Buyers? Strategic / Synergistic Buyers l A buyer in the same business or industry as the seller l l l l Consolidating industry or segment Economies of scale Expansion of product line or service Acquisition of clients or technology Often pay price based on their own ROA or ROI multiples May pay large premium if they feel it will give them major competitive advantage. Often make acquisitions to prevent any other competitor from owning company - defensive. 48

Who Are The Buyers? Financial Buyers l l Private Equity funds raised over $1 Who Are The Buyers? Financial Buyers l l Private Equity funds raised over $1 trillion from 1997 -2005 l Hundreds of billions left for investment l April 2006 – KKR completed public offering of $5. 5 billion l Barron’s April 24 estimated Middle East 2005 investment of $118 -120 billion Thousands of buyout funds with billions in capital can generally borrow 1 -3 times equity to buy a company 49

PE – Funds Available To Invest 98. 6 1996 ‘ 1997 1998 1999 2000 PE – Funds Available To Invest 98. 6 1996 ‘ 1997 1998 1999 2000 2001 2002 2003 2004 2005 Private Equity Appetite: Money Looking for Work Average PE fund has approximately 53% of its committed capital invested New fundraising activity has continued to grow in 2006 Source: : Thomson Financial & Robert W. Baird 50

Who Are The Buyers? Financial Buyers l l l Financial buyers — “private equity Who Are The Buyers? Financial Buyers l l l Financial buyers — “private equity funds & leverage buyout groups” Use equity provided by institutions, pension funds, insurance companies and other investors Borrow money to increase the return l l WACC (weighted average cost of capital) Leverage is cheap and tax deductible but cost is increasing Looking for a return on Investment (ROI) Large pools of funds to invest 51

Financial Buyers l l Not hands on managers (manage money, not companies) Many different Financial Buyers l l Not hands on managers (manage money, not companies) Many different types of buyout funds l l Some look to consolidate a niche industry l l Each has a profile of types of investments pursued by size and industry Almost all have a limited ownership time horizon (5 years average) to sell the company Most encourage management to own part of the company (5% — 20%) (vested interest) 52

Financial Buyers l l Look for 25% — 35% Return on Equity Have different Financial Buyers l l Look for 25% — 35% Return on Equity Have different minimum earning thresholds EBITDA of $3 million - $50+ million Most may consider even smaller “add-ons” that complement an existing business 53

Who Are The Buyers? Private Investors l l l l Local entrepreneur buying a Who Are The Buyers? Private Investors l l l l Local entrepreneur buying a business to own an asset that they manage and control Often buying a job Looking for insulation from employer Deal Size is usually an issue Financing sources limited – banks, leasing companies & seller finance Buyer often does not understand the risks or price Seller usually overestimates the value (emotional) 54

The Marketing Process l Prepare Business for Sale l l l l Dressing up The Marketing Process l Prepare Business for Sale l l l l Dressing up prior to sales effort Maintain management continuity Utilize pass through entity (Sub S, LLC) Identify and resolve litigation, intellectual property, environmental and other contingent liabilities Determine reliance on key customers or suppliers Identify personnel issues Obtain audited financial statements 55

The Marketing Process l Offering for Sale l l The team is critical – The Marketing Process l Offering for Sale l l The team is critical – lawyer, accountant, trusted financial adviser, and investment banker Determine advisability of a M&A professional If M&A professional desirable, evaluation and choice is critical – make sure that there is a good fit with management and owners. Cost of M&A representation = 2% - 5% of deal value 56

The Marketing Process l Business Sales Strategy l l l Prepare a Business Summary The Marketing Process l Business Sales Strategy l l l Prepare a Business Summary or Offering Memorandum and Teaser Identify potential buyers Open negotiation process: l With one purchaser at a time l To a few prospects (“Selective Marketing”) l With a controlled auction to all qualified prospects 57

The Marketing Process l Major Legal Documentation l l l Confidentiality agreement Letter of The Marketing Process l Major Legal Documentation l l l Confidentiality agreement Letter of intent Due diligence Definitive agreement and closing Management must concentrate on running the business 58

When Should A Business Be Sold? l Objectively Analyze Business’s Sales Prospects l l When Should A Business Be Sold? l Objectively Analyze Business’s Sales Prospects l l When the business Is performing well When there are good prospective buyers able to act within a reasonable time When the owner is committed to spending the time and money to market the business properly When the condition of financial records are sound l Are the financial statements audited? l Possibility of restatement in due diligence? l Entity profitability is healthy l Cash flow is strong 59

When Should A Business Be Sold? l l l When contingent liabilities are limited When Should A Business Be Sold? l l l When contingent liabilities are limited and estimable l Warranty claims, environmental, employee issues, litigation Owners start to lose the passion for continued growth and progress. l If you are not passionate about the business, your entity value is probably stagnant Management team has been groomed to run and grow the business 60

Timing Your Transaction “Better to sell too early than too late, but pretty nice Timing Your Transaction “Better to sell too early than too late, but pretty nice to sell on time” Schedule your transaction by your company’s timetable, not “the market” 24 to 36 months in advance (“Maybe”) 12 months in advance (“Probably”) Pulling together your team (“Go”) 61

Why Deals Do Not Get Done Source: Baird 2005 US Middle-Market Private Equity survey Why Deals Do Not Get Done Source: Baird 2005 US Middle-Market Private Equity survey 62

Conclusions l l l Successful businesses are marketable Business transfer is a marathon, not Conclusions l l l Successful businesses are marketable Business transfer is a marathon, not a sprint Seller must be realistic about price and timing Having a trusted team is critical Do not ignore running the business l If business falters, all else is lost 63

Case Study Discussion 64 Case Study Discussion 64