Which exit strategy is right for my business?
Strategic focus, personal circumstances of the owners, succession planning, retirement, realising a return on investment, securing a brighter future for employees, a new owner needed to take the business to the next level… there are many drivers behind a business exit. In this blog, we will be looking at the different types of exits and the reasons behind choosing each of them.
An exit strategy defines strategic initiatives of the business that will help the shareholders (founders, employees, or investors e.g. Private Equity, Venture Capitalists or Angels) to sell their holding in the business and either make a substantial profit or limit the losses. We’ve also written a piece on how businesses are valued and how to achieve the optimal valuation.
What types of exit strategies are there?
There are three common types of exit strategies: Initial Public Offerings (IPO), Management Buyouts (MBO) and Mergers & Acquisitions (M&A). For all but the smallest businesses, M&A is the most common exit strategy, examples of which would include sale to a trade acquirer, sale to a private equity / financial acquirer or merger with a similar entity. IPO is the least common. It is the highest risk/pay-off strategy as only companies of a significant scale or well-established trading history tend to IPO.
Mergers & Acquisitions (M&A)
An acquisition happens when one company purchases most or all of the company’s shares and gains control of that company. Owning more than 50% of a company’s shares allows the acquirer to make decisions regarding the newly acquired business without other shareholders’ approval. More often than not, however, M&A involves acquisition of 100% of the shares capital of a company.
Acquisitions can happen with or without the approval of the board of directors of the target company (the latter is referred to as a hostile takeover attempt). Whilst business news mostly covers large M&A deals, most M&A occurs between small to medium-sized firms. They are often carried out with the support of an investment bank or corporate finance advisors, as they can require specialist skillsets and also sheltering of the target’s employees to allow them to focus on delivering their business plans.
There are many reasons why some companies acquire others: greater market share, economies of scale, cost reductions, diversification, increased synergy, and new/niche offerings. It could also be a great way to enter a new or foreign market, used as a growth strategy, a way to gain new technology or reduce excess capacity and acquire a competitor with complementary capabilities.
Acquisitions come in many forms:
- Vertical: when the parent company acquires a company that is somewhere along its supply chain, either upstream (such as a vendor/supplier) or downstream (a processor or retailer);
- Horizontal: when the parent company buys a competitor or other firm in their industry sector, and at the same point in the supply chain;
- Conglomerate: when the parent company buys a company in a different industry or sector entirely, in a peripheral or unrelated business;
- Congeneric or market expansion: when the parent buys a firm that is in the same or a closely-related industry, but which has different business lines or products.
What is the difference between an acquisition, takeover, or merger?
Whilst in the first instance all these terms look similar, and indeed they are often used interchangeably. In reality, there are significant differences.
An acquisition is a transaction between firms that are both keen to cooperate.
A takeover implies that the target company’s board strongly resist the purchase, and where the board does not recommend the offer to shareholders and the bidder proceeds with its offer directly to shareholders, it is referred to as a “hostile takeover”.
The term “merger” is used when the purchasing and target companies mutually combine and form a completely new entity.
The main difference between an acquisition and a merger is that in an acquisition, the parent company fully takes over the target company and integrates it into the parent entity. In a merger, for contrast, the two companies combine but create a brand-new entity.
How does it work?
There are broadly three stages to an M&A process.
Firstly, the business is marketed to potentially interested parties – these may be private equity firms or could be trade buyers. Usually, businesses are marketed with a “teaser” which is a 1-2 page document which describes the business and highlights its strengths and its opportunities in its market. Often the teaser is unnamed to maintain confidentiality. Once a non-disclosure agreement (often referred to as a confidentiality agreement) is signed with the interested party then a more detailed Information Memorandum (“IM”) is shared along with a process letter which outlines a timetable for indicating interest to acquire. An IM contains details of the target’s sales, marketing, supply chain, financials, growth prospects and market. Interested parties then submit an indicative offer which is a non-binding offer and includes key terms such as valuation, consideration (including if any deferred or contingent elements such as an earn-out), key assumptions and due diligence requirements.
Secondly, due diligence. Due diligence is the process of reviewing and checking information about the company to confirm understanding and assumptions, particularly as they pertain to the indicative offer made, as well as identifying or uncovering any matters which need to be considered before deciding whether to enter into a binding agreement to acquire the business. It covers all areas of a business. Often, external accountants are brought in to do complete financial and tax due diligence, lawyers will complete the legal due diligence, and the acquirer’s employees will complete other areas of due diligence, such as sales, marketing, and supply chain due diligence.
The last stage in an M&A process is the legal. The key document is usually the purchase agreement which is commonly either a share purchase agreement or a business, trade and asset purchase agreement. Other important legal documents that are negotiated and drafted include new service agreements for key employees, transitional support agreements and consultancy agreements for exiting shareholders where some support may be required for a limited period of time. The M&A transaction is usually concluded once the legal documents are signed, exchanged and any conditions to completion, negotiated (e.g. buyer meeting with a key customer), contractual (e.g. a key customer has a change of control clause in the contract) or regulatory (e.g. approval from a competition commission).
If you are interested to learn more about M&A as an exit strategy for your business, please get in touch.
Management Buyouts (MBO)
A management buyout exit strategy is when a company’s management team buys either the shares directly from the shareholders or indirectly the assets and operations of the business they are running. The main reason behind MBO is succession planning for the shareholders who were active in the business and are looking to retire, or perhaps differing visions between the management team and the shareholders. This is an attractive exit for the company’s managers as the potential rewards and opportunity to control the company grow exponentially.
How does it work?
An MBO exit strategy is a popular option for private business owners when they wish to retire, or for large corporations that are keen to pursue a sale of divisions which are not part of the business core. MBOs are usually financed by a combination of debt and equity that is derived from the buyers, financiers such as banks or private equity firms, and sometimes the seller. A Leveraged management buyout (LMBO) is when the buyers use the company assets as collateral to obtain debt financing, rather than say taking out a larger personal loan (e.g. re-mortgaging a house). An LMBO often leaves the company with a high debt burden and interest cost to service though.
MBOs bring great potential for new management teams as they are changing their status from employees to owners and gain more control. However, it also creates a higher risk with potential loss if things go wrong.
MBOs are viewed as good investment opportunities by hedge funds and private equity funds, who often encourage companies to go private to streamline operations and improve profitability without the public seeing the process and then go public, and then to go public at a much higher valuation. If an MBO is supported by a private equity fund, the fund will often pay an attractive price for the business.
There are several negatives to choosing an MBO exit route. While some managers and executives are great business leaders and custodians, far fewer are talented entrepreneurs or business owners. Often an MBO valuation is lower than a valuation from M&A, especially a trade sale. A Management team do not have access to the same sources of finance, nor potentially synergies to justify the same valuations. Further, the highest business valuations achieved in IPOs and trade sales, recognise the strength of the management team, whereas an MBO would be less likely to price this in.
If you are considering an MBO, care should be taken by the management team. Not all business owners react well to their management team bringing up the subject of an MBO.
Additionally, there is the Management buy-in (MBI) variation, which occurs when an external management team acquires a company and thereby replaces the existing management team.
If you are interested to learn more about MBOs or MBIs as an exit strategy for your business, please get in touch.
Initial Public Offerings (IPO)
IPO is the process of selling shares to the public in a new stock issuance for the first time. To qualify, companies must meet the requirements of exchange (e.g. the NYSE, LSE or NASDAQ) and the regulators, for example, the Securities and Exchange Commission (SEC) in the US. An IPO allows businesses to raise equity finance from the public as well as institutions such as investment funds and pension funds. The transition from private to public is important for private investors to fully receive gains from their investment as it typically offers a return for the earlier private investors.
How does it work?
Before an IPO, a business usually has a relatively small number of shareholders including early investors that include founders, family, and friends alongside professional investors such as venture capitalists or angel investors. An IPO provides access to far greater amounts of growth capital than the private market, as well as a liquid market for current shareholders to sell. The greater transparency and share listing credibility also helps with the image and reputation of the business, although there are far greater professional and management time costs to being a public company.
Once a company reaches a stage in its growth process when it’s mature enough for the SEC regulations and responsibilities to public shareholders, it starts to market its interest in going public. Businesses at this stage commonly have a private valuation greater than $1 billion, also known as unicorn status. However, private companies at various valuations with strong fundamentals and proven profitability can also qualify for an IPO, potentially on junior markets such as the LSE’s AIM [link], depending on the market needs and the ability to meet listing requirements.
IPO shares of the target company are priced by investment banks representing the company, some of who may underwrite the IPO. When the previously owned private share ownership converts to public ownership, the existing private shareholders’ shares become worth the public trading price. The number of shares the company sells and the price for which shares sell are the generating factors for the company’s new shareholders’ equity value.
The transition time from private to public is great for private investors to cash in and earn returns. Private shareholders may hold onto their shares in the public market or sell a portion/all of them. The public market opens an opportunity for millions of investors to buy shares in the company and contribute capital to a company’s shareholders’ equity.
Which exit strategy to choose and when?
The optimal exit strategy for a founder is going to depend on what is their highest priority(s): timing, valuation and structure of consideration, and future prospects for the business including its team.
Even though you may not be thinking about selling the business until years out, we recommend taking advice and to start the planning early to achieve the optimal result. If you would like to speak to us about exit planning, we’d love to hear from you. You can speak to one of our professional advisors.