THE ULTIMATE GUIDE

TO SELLING YOUR COMPANY TO A 3RD PARTY

TO SELLING YOUR COMPANY TO A 3RD PARTY

PART 2: How to sell your business to a 3rd party

Part 1 of The Ultimate Guide to Your Best Exit Options, covered the sale of your business to people you already know, such as family members, management, and employees. In Part 2, we explore the topic of external buyers. These could include other companies, including your competitors, or financial buyers like private equity firms. Buyers might be local, or could reside in a different state or country. We’ll also be covering other exit options in Part 2, including IPO’s and liquidations.

Selling Your Business > Sales Effort

As a business owner, sales likely play a significant role in what you do, particularly when you were first launching the business. As you will know, “selling” takes on different forms, depending on you and on your business:

  • Perhaps you started a chain of hair salons where selling was about providing a great customer experience, so clients would return. It may also have been about using social media and word of mouth to get new customers in the door.
  • Maybe you’re a highly analytical engineer who sticks to the facts and doesn’t embellish your proposals. Clients come to you because of the value that they perceive in your straight shooting style.

Like many successful business owners who don’t want to be associated with a sales stereotype (think Alec Baldwin’s character in the film Glengarry Glen Ross), you may minimize your contribution to sales. But now, you’re thinking about selling your business, likely your most valuable asset, so it’s time to embrace that sales role. Don’t sit back and wait for offers to come to you. Lean into this.

GEXP’s Rule

➤ You’ll get a much more lucrative exit if you treat selling your business as your business.

What will this guide teach me?

Educating yourself about exit options is a great way to get started, and that’s what this guide will help you with. We’ll be discussing external exit options – those listed on the right side of the following diagram:

Internal Buyers and External Buyers

As you likely know, we cover internal exit options in The Ultimate Guide to Your Best Exit Options – Part 1. Whether an internal or external buyer is best for you will depend on your individual circumstances, so it’s prudent to understand the full range of options.

As you begin exit planning, consider both sets of potential buyers – which path is likely to be most successful in meeting your objectives?

This guide maps out the most effective route to success with these four types of exits – strategic, financial, IPO, and liquidation. You’ll learn, as you make selling the business your business, that each route requires a different approach.

In understanding how to optimize your approach to different buyers, you’ll benefit from:

  • More exit options, which increase your negotiating leverage so you can maximize the price you get for your business.
  • A boost in intangible variables that, down the road, will increase your company’s value in the buyer’s eyes.
  • Your knowledge of the pitfalls related to each exit; you’ll be better prepared to avoid them.

Setting the Stage

When you make selling the business your business, you’re more likely to get the price you want within your time frame. To get to your best possible exit option, you will need:

You may remember this from Part 1…in our view, it’s worth repeating:

  • If you’ve got time, financial stability, and energy, you are most likely to secure an optimal exit as well as the legacy you want to leave behind with your company.
  • If you are lacking energy but have time, and the company has financial stability, you can still sell your business (of course), but you may not have the drive to secure the optimal deal structure. You may be willing to settle for less than the best exit.
  • If you have time and energy, but the company is lacking the necessary financial stability, it’s worth developing a strategy to increase the company’s cash flow and improve the exit options down the road. But if you need to liquidate the business and exit now, our guide discussion of liquidation will be useful, as we talk about how to maximize the value of the company’s assets in a liquidation scenario.

The Goals of this Guide

We want to make sure you understand ALL your exit options and how each impacts your goals and financial outcome. And we want you to understand this BEFORE you sell your company.

The guide will also help you understand the deal structures to consider if you are pursuing an external exit option. As noted, these options range from a liquidation event for a failing business, to taking a corporation public in an IPO.

The Highlights

As we discuss the different exit possibilities, we’ll cover key details to shed more light on the process. This guide will dive into:

  • How to structure the deal
  • How each buyer looks at valuation, and why there are differences
  • How to push a buyer to a higher value
  • The typical deal structure
  • How much control you have over the sale process
  • Key points for the negotiating table
  • How an IPO works
  • Why and how to go about a liquidation

Structuring the Deal

There are many differences in how a deal can be structured and how you are paid:

  1. Bank financing – the buyer takes out either a conventional or SBA loan, combined with their own cash, and pays you part or all of the price at closing. This makes sense for strategic and financial buyers – they typically pay for a company with a combination of cash from:
    • their own balance sheet;
    • a bank loan they arrange, that will be collateralized by the acquisition target, your company;
    • a promissory note to you, the owner, in exchange for seller credit for some portion of the purchase amount.
  2. Installment sale – you accept a series of payments over time, often for 3-5 years after closing. It can be for a portion of the purchase price, or even the full amount. Payment of some of the proceeds over time can have worthwhile tax benefits. See Part 1 of this Guide for more information.
  3. Third-party financing – the buyers leverage other credit like a mezzanine or subordinated loan from a private lender. While they’ll pay a higher interest rate, this can work if conventional financing isn’t available. Often the mezzanine debt will be part of a total package that includes cash from the buyer (equity) and senior debt from a bank.
  4. Earn out / earned compensation via growth projections – the new owners pay you part of the purchase price based on the business hitting pre-agreed performance targets over time. This limits how much you have to argue over the sale price –if the business performs as you expect, you get paid.
  5. Employment contract – you remain an employee or consultant of the company, perhaps as CEO or president, and the company pays you pre-established amounts in the form of salary and bonuses if you achieve certain milestones.
  6. Merger/ Stock from the buyer’s corporation – this works if your buyer is a public corporation with shares traded on the open markets. This is much riskier with a private company buyer because you may not be able to sell its shares when you need the cash.
  7. Royalties – royalties are similar to an earn-out, but based on the sales revenue, rather than the profit, of the company. In a royalty deal the recipient gets some percentage of the revenue, usually paid on a quarterly basis. It could be x percent of every dollar, or x cents for every unit sold. The benefit over an earnout? If the new owners inflate expenses and mismanage the bottom line, that will not impact the amount you are paid (unless the company slips into default).
  8. IPO – an initial public offering or “IPO” involves taking a company public, so its shares can be publically traded on an exchange like the NASDAQ or NYSE. This is a complicated, costly and time consuming process, which, if successful, provides the company with access to significant capital. There are other routes to access the public markets like the current trend for blockchain “ICOs,” a merger with a shell public corporation. In consideration of your time constraints, we won’t be touching on these options, but if you want more information, let us know. We can point you in the right direction.
  9. Liquidation – this is a means of closing the doors and winding down the company in a way that minimizes law suits against you, and protects your reputation. It’s a tough road to travel, but keep in mind that Sam Walton went through this and subsequently went on to found Walmart.

Valuation methods and final dollar amount paid will depend on each buyer. To learn more about valuation and net proceeds, read our Ultimate Guide to Knowing Your Business’s Value. Factors to consider include:

  • How much you get paid (net of taxes)
  • How you get paid
  • When you get paid
  • What’s the risk that you don’t get paid

#1 SELLING YOUR BUSINESS TO A STRATEGIC BUYER

Key Takeaways for this Section

  • ✔ Strategic buyers will usually pay more than any other kind of buyer.
  • ✔ Spend time considering what will motivate the buyer the most.
  • ✔ Competition among buyers helps increase your valuation.

Understand Your Buyer

A strategic buyer is looking for more value out of your business than its foreseeable cash flow. They’re often willing to pay more than other types of buyers, so it’s important to effectively communicate your company’s value proposition to them.

Your historical and projected EBITDA may be of different significance to a strategic buyer than to other buyers. In fact, depending on their motivation, your EBITDA may have no significance at all. A strategic buyer will have a specific reason (or reasons) for wanting to purchase a company. Some of the issues a strategic may be seeking to address include:

  • Reducing their time to market.
  • Adding a new product, brand or service to their current offerings.
  • Acquiring your customer list.
  • Entering a new geographic area.
  • Gaining a talented employee pool.
  • Eliminating a competitor (you) to gain more pricing power.
  • Squeezing costs (you) out of their supply chain.


Let’s look at the different types of strategic buyers:

  1. Competitor – A company that you compete with for client acquisition. The synergies in company structures, systems, vendors/suppliers, volume discounts, staff, and overall redundancies make your business attractive to them. In addition, they would be eliminating a competitor (you).
  2. Supplier or Manufacturer – A supplier or manufacturer may become a buyer if they are trying to consolidate the companies in the value chain between product/service and client. If your business fits somewhere on the chain, as illustrated below, your company could be an attractive target:
  3. Client
    1. While less common, some strategic buyers are companies that have been making extensive use of your product or service, and decide there would be a benefit to owning it and locking out their competitors.
    2. Nike recently purchased a vendor of data analytics, in part to keep the firm’s AI expertise out of competitor’s hands.
  4. Natural Fit
    1. This occurs when the buyer and your company provide complementery or synergistic value to their customers.
    2. An excellent example is the purchase of LinkedIn by Microsoft. The complementary services and user databases created value for both sides.

Buyer Motivation

Why would a strategic want to buy your company? The most compelling reasons include:

  1. Geographic Expansion
    • Companies continually consider expansion into new geographic markets.
    • If you can expedite a buyer’s expansion strategy because of your established infrastructure in a particular location, the buyer will likely be willing to pay a premium for your company to eliminate time to market and lost opportunities.
  2. Vertical Integration
    • Look at the ”value chain” illustration above. Vertical integration occurs when a strategic takes over one or more of the circles on either side of it.
    • Typically, the motivation is to get closer to the end customer or consumer.
    • For example, Amazon has been actively acquiring logistics companies, and has also purchased a large retailer.
  3. Horizontal Integration
    • This occurs when a strategic acquires similar companies.
    • Strategics pursue horizontal integration for a variety of reasons. A “roll up” is the most extreme form, where one company acquires virtually every other business offering the same service or product, and in doing so, gains substantial pricing power.
    • About 18 years ago, a company called Mobile Mini started rolling up the storage unit business, and has since grown its top line to $500 million annual sales.

The price a strategic buyer ultimately pays for a company varies significantly from deal to deal. If you understand what motivates a strategic buyer, you will be better equipped to shape a compelling story about what your company could contribute to the potential buyer’s future growth.

Pros and Cons of Selling to a Strategic

Pros

  • You’ll likely get the highest price.
  • A strategic knows your industry, and has a good sense of the value your company creates in it.
  • Often, a strategic will pay you to stay on after the sale, to maintain continuity with operations and reduce risk.
  • Strategics are often larger companies, capable of bringing more cash to the closing than other types of buyers.

Cons

  • Strategics may get tough on valuation if they sense any vulnerability – for example if you need to exit due to disease, divorce, too much debt, or other negatives.
  • Like all deals, during the process you’ll be “opening the kimono”. But if the deal falls apart (which is not uncommon) you’ll face a competitor/vendor/customer that has knowledge of your sensitive, proprietary information.
  • A strategic might move your operations out of town, lay off employees, and chisel your name off the front door.

Maximizing Your Valuation on Exit

Here are some important tips to maximize the amount a strategic will pay:

  1. Understand their goals and objectives.
    • It’s critically important to know what they want to get out of the acquisition. Ask as many questions as you can to get the complete picture.
    • What is the return on investment (“ROI”) they need to achieve?
    • Is there a particular issue they are trying to address by buying you?
    • Review the points listed above in the section “Understand Your Buyer.” It pays to spend time on this. (The word “pay” was used intentionally here.)
  2. Know the traditional valuation for your company.
    • Use a trusted adviser to understand which valuation method is most commonly used for acquisitions in your industry.
      1. Is it multiple of EBITDA or revenue, or discounted cash flow?
      2. If companies in your industry are typically valued on a multiple of annual EBITDA, calculate what your EBITDA was last year and forecast what it will be for the current and subsequent years. This provides a starting basis for your valuation.
  3. Craft a narrative.
    • Craft a story about your company that speaks to the potential buyer.
    • Engage in conversation about what the marketplace would look like if they owned your company. Topics to include (if applicable):
      1. Potential revenue and cost synergies that could add value to their business.
      2. Increased value in your IP if owned by the potential buyer.
      3. Anticipated positive customer response if your brand is associated with the buyer’s goods and services, or vice versa.
      4. Increased market dominance post-acquisition, providing the opportunity to squeeze out competition and increase market share.
    • Crafting a compelling narrative about your company that highlights the value propositions for the potential buyer will increase the likelihood of a higher valuation.
  4. Anchor a higher price.
    • As long as you’ve done your homework, don’t hesitate to table the first number.
    • If you know your basement – the company’s value using the commonly accepted multiple for your size of company in your industry (for example, 1x revenue; 5x EBITDA), then start the process by pitching a higher number – the ceiling — based on your crafting a narrative conversations.
  5. Add the variable of time to price.
    • You may choose to defer part of the purchase price (and will likely reap tax benefits if you do). Flexibility on timing of the purchase price payment can contribute to higher valuations.
    • If your business generates EBITDA of $3 million a year, and comparable companies in your sector sell for 5x EBITDA, your buyer may reasonably think a $25 million (or $30 million) price tag is too high.
      1. “Too high to pay by when?” is the question that needs to be surfaced.
      2. The buyer may be more willing to pay $1.5 million a year over 17-20 years, than $25 million on closing. With this approach, the buyer pays the whole acquisition price out of the business’s cash flow. But if this timing doesn’t work for you…
      3. You might propose a portion of the $25-30 million to be paid at closing, with the balance payable over time, perhaps over a 10 year period. This mitigates your risk, while giving the buyer the benefit of using the business’s cash flow to pay off the balance of the purchase price.
  6. Give them a test drive.
    It’s worthwhile to create an emotional pull for the buyer, allowing them to experience, firsthand, the potential of your business. Whether you can take all of the following steps will depend on where you are in the process and what you have disclosed to employees:

    • Bring the buyer into your office to experience the culture and meet your talented employees.
    • If you own proprietary technology or processes, give the buyer a taste (without disclosing too much, in case the deal falls apart).
    • Have a meal together at your offices. There is actually an academic study that found negotiations that take place over a meal result in better outcomes for both parties . In addition, enjoying a meal at your offices will likely color a buyer’s perception of your operation.
  7. Follow up quickly.
    • Try and keep the process as short as possible. When it drags on, both parties begin to suffer from “deal fatigue”.
    • The buyer isn’t the one getting the big check, so they are naturally less motivated, and more cautious, about getting to the closing table.
    • Yet in a surprising number of cases, it’s the seller who drags their feet, particularly when it comes to providing disclosures and documents during the diligence phase.
      1. The key is to be organized, with a strong team of internal and external experts to support you.
      2. Selling your business is likely the largest sale you’ve transacted to date. Be prepared for the heavy lifting this process demands.
  8. Create competition.
    • When there are multiple bids for your business, that creates competive tension. The benefits include:
      1. Motivating your primary prospective buyer to move more quickly, rather than allowing another company to scoop “their deal”.
      2. Bolstering your negotiating position because you have an alternative option. Don’t overplay this, but do allow it to inform your decision-making and, perhaps, stiffen your spine at the table.
    • It’s important to manage this process in a transparent fashion. Let the first bidder know early on that they’re not alone at the table.
    • If you are working with the first bidder under an agreed exclusivity period (a specified time during which you’ve agreed not to engage with any other buyers), it’s important to comply with that term. It’s critical to maintain a level of trust and credibility. Double-dealing with your first bidder brings the risk of blowing up the process.

Summary

Don’t leave it up to your buyer, strategic or otherwise, to calculate the value creation possibilities (and resulting ROI) of your business. Craft the best narrative! Step outside the box of past performance and EBITDA, and think about how to influence the buyer’s perceived value.

For example, if you’re aware the buyer could sell their products and services to your client base, secure order discounts that weren’t available to you, eliminate significant competition by buying your company, and because of these benefits, would be able to escalate growth well beyond current levels, be sure to tell that story.

Finally, there is a significant risk factor to keep in mind when selling to a strategic buyer: preservation of your legacy. While a strategic may pay the highest price for your business, your legacy is unlikely to be preserved.

When considering a sale to a strategic buyer, think carefully about what you want to get out of the sale of your business.

#2 SELLING YOUR BUSINESS TO A FINANCIAL BUYER

Key Takeaways for this Section

  • ✔ Financial buyers are looking for steady cash flow.
  • ✔ They typically pay less than strategics, but more than other types of buyers.
  • ✔ The less friction in your business, the more they’ll pay.

Understand Your Buyer

A financial buyer invests to receive the cash flow your business can provide over an extended period of time. They’re not interested in taking on day to day management. In many cases, they’ll keep the owner and original management team in place, provide additional working capital, and pull out net profits in the form of dividends, while ensuring management earns the salary and variable compensation they require to stay committed and motivated.

There are four kinds of financial buyers:

  1. Private equity (PE) firm.
    1. These are professional investment management firms that invest in or acquire private operating companies through a variety of strategies including leveraged buyout, venture capital, and growth capital.
    2. They spend a significant portion of time raising the capital they use from institutional investors, including university endowments, pension funds, and even other larger private equity funds.
    3. A typical fund deploys capital for 4-7 years, at which time the money goes back to its limited partners. If a PE firm buys your company, they will expect to sell it for a significant return within that time horizon.
    4. For every 100 deals they see, PE firms may take a hard look at 10, and actually close a deal with 1-2. Keeping up with their “deal flow” is a big part of their job.
  2. Holding company.
    1. These firms exist simply to own other companies, which become subsidiaries of the holding company post-acquisition.
    2. They don’t conduct their own operations per se, although they have professional management.
    3. Warren Buffet’s Berkshire Hathaway is the most famous holding company. It has 100 percent ownership of over 60 different companies ranging from Geico to Fruit of the Loom, and has partial ownership in hundreds more.
    4. In some cases, a holding company remains the owner of a company for an indefinite period of time, while in others, it may build the company’s value over a 7-10 year period, then look to exit by selling for a premium. The route selected depends on the holding company’s objectives. Generally, however, acquisitions will be held for a longer period than a private equity fund.
  3. Family office firm.
    1. These are wealth management professionals who perform centralized management and oversight of investments, and may also perform tax, estate, and philanthropic planning for their clients, who are very wealthy families.
    2. Some work with a number of ultra-high net worth families, while others focus on just one extremely wealthy client.
    3. Many family offices provide full service support by overseeing their clients’ bookkeeping, expense management, trust services, document management, and family governance.
    4. Unlike a private equity firm with its limited window to own a company, a family office may be looking to own your company indefinitely, withdrawing annual profit as dividends as part of a larger strategy to diversify clients’ income streams.
  4. Individual investor.
    1. Just like it sounds, these are high net worth individuals who see value in your company’s ability to provide them with long-term cash flow.
    2. An individual investor theoretically prefers to be hands-off, with an interest in generating passive investment income, rather than an active manager.
    3. In practice, however, they’re more likely to be actively engaged in your business, relative to a professional investor who is focused on results.

Regardless of the type of financial buyer you’re dealing with, the same value levers apply. These buyers are primarily concerned about earning cash flow over a long period of time, so their first priority will be to understand your past and forecast EBITDA and free cash flow position.

Financial buyers will also want to ensure that there is minimal friction in your business, so that it produces the expected cash flow without bumps in the road. For example, they will not want to provide capital to fix operational problems, replace the entire management team, or address major systems and logistics glitches post-acquisition.

The financial buyer is buying cash flow. Less friction = more flow.

Why Sell to a Financial Buyer?

There’s a great story that illustrates the benefit of an exit by selling to a financial buyer. Flojos (“flo-hos”) was a family owned business run by husband/wife team Nellie and Sheng Yen Lin. Its flip-flops were produced in Mexico and became hip with surfers in California. The Lins bought the brand in 1996 and grew it steadily, but after nearly 20 years they wanted to retire and sell to a buyer that would continue to build the business.
Flojos
The Lins went with a financial buyer, a private equity firm called the Courtney Group. The buyer recruited a top notch CEO, highly experienced in the footwear category, to take over from the Lins, but left the rest of the team and operations in place. Under the new ownership, the men’s division is expanding, legacy styles are being brought back as limited editions, and international sales are accelerating. The Lins appear to have got it all with this buyer…the payout that they wanted for retirement (although terms of the deal were not disclosed), and the preservation (and enhancement) of their legacy.

Pros and Cons of Selling to a Financial Buyer

Pros

  1. You may be able to continue working with the company, in your current role, for a market-appropriate salary and variable compensation.
  2. They may be able to bring additional working capital, talent, and sales opportunities to the business, building on your legacy (like the Lins’ story).
  3. While you will no longer own the business, if you retain a role with the company, you may enjoy worrying less about cash flow, and focusing on growing the business and doing what you love.
  4. By selling your business, you will have significantly reduced the risk associated with your personal assets (though this would apply if a strategic bought your business as well). Even if you retain some interest in the company post-acquisition, you’ll have substantially mitigated your risk. Your wealth will no longer be primarily consolidated in one place.

Cons

  1. You may get a lower valuation than you would with a strategic buyer.
  2. The new owners can fire you or your employees, and/or move the operations to a different geographic location. This is much less likely, however, with a financial buyer than a strategic.
  3. The deal terms may not allow you to retire right away. Usually a financial buyer will want you to stay with the company, at least for an agreed upon transition period.
  4. Assuming you retain your position with the business, you’ll now be accountable to a new owner, who may not agree with your decisions. While the buyer should, of course, have board-level control, an inexperienced financial buyer – particularly a high net worth individual – may get more hands-on than you’d like.

Typical Valuation Process and Deal Structure

For financial buyers, EBITDA and cashflow are the metrics they will look to when they value your company. These buyers aren’t looking for synergistic value creation and new business opportunities. Rather, they want to buy a company that generates predictable annual cashflow.

The two valuation methods that are generally used are:

Multiple of EBITDA.

  • The prevailing multiple for businesses of your type and size.
  • Larger companies get a relatively higher multiple, and smaller ones get lower multiples compared to the median.

Discounted Cash Flow.

A model that forecasts the cashflow your business should generate over a period of time – for example, 5 years – and reduces or “discounts” that income stream by two things:

  • The cost of the capital used to make the acquisition, including interest payments for any borrowed sums.
  • A factor that takes into account the risk that future cash flow won’t meet expectations.

Summary

It’s important to understand the financial buyer is NOT just looking at past results, but is also interested in the future cash flow potential of your business.

The financial buyer’s risk is tied to:

  • The capital utilized to buy your company; and
  • The opportunity cost of using that capital elsewhere.

While a financial buyer’s valuation of your company may be lower than a strategic’s, selling to a financial buyer offers advantages if you are concerned about your legacy, and want to continue to work with the company after the acquisition.

#3 EXITING THROUGH AN IPO

Key Takeaways for this Section

  • ✔ For companies that want or need lots of capital for growth.
  • ✔ Owner gives up substantial control and influence, even before going public.
  • ✔ Very expensive and time consuming. IPOs open up a lot of new doors for growth.

Why Exit by an IPO?

These days we read a lot in the media about “unicorns” – companies (generally tech) that surpass a $1 billion valuation – going public, perhaps accompanied by a wave of optimism predicting that they are the next Facebook.

While it’s true that the public markets favor certain types of tech and IT sector companies, there is plenty of room for businesses in other sectors, whether industrials, consumer products, life sciences, financials, or something else.

Consider the story of Sensonics. It’s a health equipment maker with an innovative blood glucose monitor for diabetics. It generated a little over $6 million in revenue in 2017. But the same year it also issued convertible notes worth more than $50 million, and at the end of the first quarter of 2018 its market capitalization was over $400 million.

How did a $6 million revenue company come to have a market cap of that size? Two years earlier, Sensonics went public on the NYSE and raised $45 million. While the company continues to wade through costly, time consuming clinical trials for FDA approval, by entering the public markets it accessed enough capital to fund this effort. Sensonics was able to successfully go public, and enjoy continued upward momentum, because investors saw its long-term potential.

If you’re the owner of a business with a big vision, an IPO may be the right exit for you. You’ll need to “professionalize” your management team in anticipation, and well in advance, by recruiting a CFO and perhaps a COO who have experience taking companies public or running a public company.

Understand Your Buyer

Many people have the false expectation that taking their company public is like selling to millions of anonymous day traders and individual mutual fund owners. It’s not.

You’ll actually be selling your company to numerous institutional investors and traders, as well as to public companies who may buy large volumes of your shares at the time of the IPO. You won’t be going through the process with a couple of tough buyers. Rather, you’ll meet hundreds of them, hoping to make the cut with a handful.

Primarily, these investors will be looking for many of the same characteristics as other buyers:

  • Compelling growth story – how your product or service has scaled rapidly.
  • Strong management team, including top management that has prior public company experience.
  • Clear expectations of future profit streams. You don’t necessarily need historical profits – remember the Sensonics IPO; they didn’t even have much revenue.
  • Barriers to competition, unique IP, and other disruptive innovation

In addition, institutional investors will consider other factors:

  • The caliber of the venture capital or private equity funds that invested in your company previously. VC-promoted companies will have an advantage, particularly if a well-respected VC shepherds the deal.
  • The experience of the Board of Directors – whether they are influential and respected individuals who have guided other companies through successful IPOs.
  • Comparables – how IPO’s for similarly situated companies have gone.
  • Whether the CEO and CFO are effective communicators in front of a large audience.
  • The market appetite for this type of offering, at this particular time.
  • Pricing – whether it’s too high or low, and whether the company is raising enough capital.

Pros and Cons of Exiting by IPO

Pros

  1. Going down the IPO path forces you to professionalize your company.
    • You’ll start by adding experienced outsiders to your board, and upgrading key management positions.
    • Process driven functions, like sales and accounting, will be standardized so that your results become more predictable.
    • Your investment bankers, hired in anticipation of the IPO, will recommend further improvements to increase the company’s value.
  2. Preparing for the IPO may draw the attention of strategic or financial buyers, who subsequently offer to buy your company.
    • Larger companies may want to buy your business at its lower, private valuation, versus the higher valuation likely once it’s a public company.
    • The simple act of hiring investment bankers will raise your company profile and surface potential suitors. Be aware that your investment bankers will earn their success fee sooner by advising you in an acquisition offer, rather than going down the longer path of an IPO. They may be motivated to take that shorter route, so make sure you’re well informed about the benefits of each.
  3. You’ll have access to much more capital as a public company.
    • Even before you go public, you can raise bridge financing from institutional investors or lenders to pave the way for your IPO.
    • Once you’re public, you have a theoretically unlimited access to capital. For perspective, the NASDAQ composite index more than doubled over the ten years from 2007 (pre-Great Recession) to 2017.
    • Public companies can borrow from banks more easily.
    • Public companies can issue long-term debt in the form of bonds, which private companies cannot.
  4. Capital is more elastic after you go public.
    • As a public company, your share price (and value) may increase because of macro factors like a strong economy, results of a recent election, or tax cuts.
    • Your sector may become highly attractive to the markets because of what a competitor is doing.
    • On the downside, however, if the factors in a and b are negative, investors are likely to depress your value.
    • You can buy other companies with your shares.
  5. Public companies can survive major setbacks more easily than private companies.
    • In the event you face a significant shock – your biggest customer defaults, there’s a massive data breach or a product recall – your stock price will plunge but you can still raise capital (albeit expensive capital) by selling bonds, issuing more shares, etc.
    • In contrast, when a private company has a major shock it may not be able to borrow capital from any lender, except in bankruptcy.

Cons

  1. The process is extremely expensive.
    • You’ll need to hire (and pay) outside lawyers, accountants, investment bankers and other professionals. In most cases they are different professionals than you use currently.
    • Internally, you will have to bolster your finance department and add in-house legal counsel to manage the process.
    • Your travel budget will escalate.
  2. It’s also extremely time consuming.
    • As CEO, you will take a lead role in developing the IPO plan, hiring the right professionals, and laying the groundwork.
    • Day-to-day leadership responsibilities become difficult to manage.
    • You’ll be going on “roadshows” for weeks at a time, visiting brokerages and potential investors.
    • Your final “sprint” –4-6 weeks before– will require long work days entirely focused on the IPO.
  3. You’ll have less control, even before the IPO happens.
    • Even if you own the majority of stock, once you start down the IPO path the company’s Board of Directors will set and oversee the strategy.
    • The Board will need to have outsiders with experience in public companies, not just loyal friends.
    • Board members with the most money and experience are going to influence major business decisions as they guide the company toward the IPO. For example, you may get pushed to spend more money than you think is smart, in order to show more growth. The Board may pressure you to bring on new C-level people to replace or in senior positions to your existing team. The Board may ask you to step aside for a CEO with public company experience.
  4. After the IPO, it’s a bit of an ordeal to sell your stock.
    • An insider – whether you’re the CEO or hold another key role—can’t simply sell their stock on the public markets.
    • There’s an entirely different process: you (likely through a brokerage firm) find a buyer for your stock or options, negotiate a price, and get SEC approval. Once approval is obtained, trading is halted on the stock, and you can cash out.
    • For some people, this process is as complicated as launching the company.
    • Due to confidentiality obligations, none of this process can be disclosed to your employees, friends, or family until it’s complete.
  5. After the IPO, the CEO role carries a new set of responsibilities.
    • You have a fiduciary duty to all shareholders.
    • Everything you do needs to be transparent.
    • Compliance becomes a significant part of your job.
    • Much of your time will be spent preparing for quarterly reports, meeting with analysts or institutional shareholders, and promoting the stock.
    • If things go wrong, you may be penalized by the SEC. There’s no comparable authority over private companies.

Typical Valuation and Deal Structure

IPOs are complex, making it difficult to define a “typical” valuation or deal structure, which will only be certain at the time of the IPO.
In the lead up, however, to ensure that the process goes as smoothly as possible, it’s important to take the following measures:

  1. Ensure that you have a trusted and experienced management team.
    • Going public puts significant demands on management.
    • Make sure the team includes a senior-level person with strong communication skills to address investor or SEC queries and present the company’s vision and plans.
  2. Upgrade financial reporting systems. To meet comprehensive financial reporting requirements, you will need:
    • Disclosure controls and procedures
    • Internal controls over financial reporting
    • Systems that ensure all data is recorded in a timely and accurate manner.
  3. Select your investment bankers and underwriters (there may be several).
    • They identify and approach potential investors.
    • Investment bankers play a key role in selling your company’s shares, so strong sales and distribution capabilities and excellent analyst coverage are important attributes.
    • Some of the biggest underwriters include Goldman Sachs, Credit Suisse First Boston and Morgan Stanley.
  4. Write your company’s story.
    • This should give prospective investors insights into all aspects of the business. Your investment bankers will play a significant role in helping craft the story.
    • You will include your company’s goal, mission and vision – emphasizing its strengths, and long-term potential, along with the market opportunity.
  5. Register with the SEC.
  6. Present the company story and prospectus to the SEC for registration and review.
    • The initial prospectus contains all information about the company, excluding the offer price and date of the IPO.
    • Typically, this process takes more than a month.
  7. Start your road show, visiting institutional investors around the country, and making your pitch.
    • All SEC comments and recommendations must be addressed before the roadshow begins.
    • Expect to do significant travel, and attend numerous meetings and media sessions.
    • Your roadshow is your marketing platform for the IPO. You’ll be doing extensive pitching of the company story during this time.
  8. Price your IPO
    • At this stage, there will be a sharper perspective on valuation.
    • Your underwriter will price the shares to maximize the probability of success, and minimize the likelihood of being undersubscribed.
    • Experienced underwriters will understand how to strike that critical balance.
  9. Close your IPO
    • The issuer and selling stockholders will issue the shares to the underwriters, and the underwriters will buy those shares, discounted at approximately 7 percent.
    • Issuers then undergo an SEC quiet period for 25 days following the pricing.
    • During that time, broker-dealers will approach and deliver IPO sales materials to investors.
    • At this point, you’ll know your final valuation!
  10. After the IPO:
    • You’ll have a lock-in period where you cannot sell any shares.
    • If you want to cash out or diversify your holdings, you’ll work with an institutional investor to purchase all or most of your stock.

Summary

An IPO can create considerable wealth for early shareholders of a company, although the process is not for the faint of heart, nor is it an easy path to riches. If you decide to take the IPO exit route, expect struggles and sleepless nights along the way. But if you’re successful, the company will have access to abundant capital to drive its growth, and you’ll be positioned to enjoy a very lucrative exit.