Exit Strategies for Owners
If you own a design studio, there are three primary ways for you to eventually leave the business. The first and most unfortunate way would be to die in the saddle. By that I mean, don't do any planning at all and just work until you drop. If you were to die suddenly, you would leave quite a tangle for your heirs. Chances are they're not designers and have not been involved in the business. They will not know the market for creative services and will not know how to manage the operations of the firm. Because of this, they may not be able to extract much value from what you have left behind.
The second option for you would be to simply shut the business down. In the past, this was probably the most common exit for design firm founders. In a small firm where your name is on the door, the work being produced is an extension of your own interests, abilities and personal relationships. It's typical to extract all profits as you go along, leaving very little of value within the firm itself. When you want to move on or retire, the process is simple: you stop taking new assignments, sell off the furniture and equipment, and then just lock the door. There is no financial payoff for you at the end of this process—you've already gotten whatever you're going to receive.
The third and best option for you would be to sell the business to a new owner. A well-established firm that has produced good work and consistent profits over the years is what an accountant would call a “going concern.” If you have built up value within the firm and maintained a roster of stable client accounts, there's no reason at all to shut the business down. It's likely that you will be able to find willing buyers.
Reasons to sell
There are many valid reasons why you might be interested in selling:
- You may feel restless and want to seek out new creative challenges. Perhaps you're a serial entrepreneur who loves launching new enterprises, but not necessarily managing them on a daily basis over the long haul.
- An unexpected strategic opportunity to sell or merge may come along that you feel is just too good to pass up.
- You may have developed some health problems and need to sell because of them.
- You may be going through a divorce that is causing a forced division of assets.
- Your decision to sell may be triggered by personal financial planning and the need to diversify assets.
- You may be thinking about retirement, that is to say nearing an age where you simply want to stop working so hard.
If you're thinking about selling your business, who are the most likely buyers? There are several different categories of buyers for you to consider. Depending on your circumstances, you might be able to sell your firm to a co-owner, to a strategic buyer (meaning a supplier, customer or competitor), to your employees, or to the public. Here are some thoughts about each of these categories:
Selling to a co-owner (such as a co-founder or partner) may be the easiest option, provided that you do, in fact, have a co-owner. If you do, a buy-sell provision was probably included in your original partnership setup or company formation. This specifies in advance a mutually agreed-upon method for you to give notice of your intention to leave, for valuing your portion of the business, and the exact method and timeframe for you to be paid. A common approach is for the departing co-owner to receive a down payment of 25% or 30% of the buyout price, followed by monthly installment payments (including a reasonable rate of interest) over the course of three to five years.
A supplier may be interested in buying the firm because you offer services that are in some way complementary to theirs. The combination would create synergy, bringing various components together in a way that makes the whole greater than the sum of the parts. The acquiring company may be seeking vertical integration-control over the flow of services and products from origination all the way to the end-user. Depending on the industry that they are in, it may make sense for them to assemble some combination of resources in design, manufacturing, distribution, and perhaps even wholesale or retail sales. Your company may be the next logical step in a larger process for them. Examples of this would include the acquisition of both the Palo Alto Design Group and frog design by global electronics manufacturer Flextronics. Other examples might include the purchase of a packaging design business by a printing company, or the purchase of a fashion design studio by a clothing manufacturer.
Less commonly, you may have the option of selling some or all of the business to a customer. A customer may be interested if they have an ongoing internal need for the creative services being provided. An investment would allow them to lock in availability and reduce cost. One example of this would be the investment that Steelcase, the large office equipment company, made in the industrial design firm IDEO.
Finally, a strategic buyer for your firm may be a competitor. Large firms often grow through acquisitions, rather than through internal, “organic” growth. Acquiring another company is a fast way to expand into new markets or to add innovative services. Large organizations may also be seeking economies of scale. Economies of scale are the reductions in per unit costs for producing and marketing a product or service that occur as the overall quantity increases. Acquisitions by competitors have been very common in the field of interaction design. The recent acquisition of SBI/Razorfish by the large interactive agency Avenue A is just one example of this.
Growth through acquisitions has always been standard operating procedure in the advertising world. It has resulted in the industry being dominated by holding companies like Omnicom, WPP and Interpublic Group. For new advertising agencies just getting started, reaching critical mass rather quickly is often necessary in order to compete successfully with the global holding companies for major clients. When an advertising network seeks to grow through acquisitions, the challenge of course is to acquire the best companies without paying inflated prices. If a company is purchased at the top of an economic cycle and a downturn follows shortly thereafter, the acquirer may have difficulty generating enough revenue to service the debt that it has taken on. Periodically, a shakeout takes place in the advertising industry. During an economic downturn, the closing, consolidation, or acquisition of small and mid-sized advertising shops is common.
Selling your design firm to your employees is also a possibility. However, it's usually a stretch for the employees to be able to afford it. The purchase may be done as a management buyout (MBO), where senior members of the management team arrange the financing based on their own personal assets (and the likelihood of continued strong performance of the company). If the buyers do not have a lot of personal assets, a leveraged buyout (LBO), may be a possibility. In an LBO, they may be able to use the assets of the business itself to secure an acquisition loan, and then use the cash generated by ongoing business operations to gradually repay the loan.
If you are the owner of a large company, you may be able to undertake the more complex task of structuring an employee stock option plan (ESOP). This allows employees to use payroll contributions to purchase shares as part of a company-wide retirement plan that invests almost exclusively in the company's own stock. Employees become vested over a specific period of time, such as five or seven years. There are many legal restrictions for ESOPs. The setup requires a good deal of expertise from CPAs and attorneys, and the ongoing reporting requirements are extensive. Lastly, because of the long vesting period for the new owners, an ESOP is definitely not a quick exit strategy for the founder.
Your final option might be to sell the business to the public in an initial public offering (IPO). This is not common for graphic design firms. However, selling stock to the public is sometimes possible in a strong economy, provided that your firm is providing innovative services that are in great demand. If your firm has the potential for rapid growth, investors may want to participate in that growth. This was the case in the late 1990s for Web development firms due to the explosive growth of the Internet. If the conditions are right, an IPO can be a way to raise large amounts of capital to fund the growth of the firm and to provide liquidity. The overall process typically starts when a firm with significant potential accepts a private equity investment from a venture capital firm. Later, a large underwriting firm will be brought in to manage the public offering. Because equity is being offered to the public, the entire process is subject to stringent governmental requirements. Also, an IPO does not provide an immediate exit for the original owners because the venture capitalists and underwriters will usually want management continuity. The post-IPO success of the publicly traded company would be jeopardized by the departure of the individuals who made the company a success in the first place.
Manage with exit in mind
Even though you may not sell your firm until several years from now, you must begin to manage with that eventual exit in mind. A good way to start is to analyze the current strengths and weaknesses of the business. For example, would a change now in legal structure (say, from a sole proprietorship to a partnership or a corporation) later make it easier to sell? Have you been cautious about debt and long-term leases? A new owner might not want to be saddled with such obligations unless they are on very favorable terms. Make sure that your books are complete and that the business has no unrecorded liabilities. For example, have you booked adequate reserves for such things as potential bad debt, the possible refund of client deposits, or the value of paid vacation time that is due to employees? Do you have adequate insurance coverage? Depending on the creative services that you provide, this might include coverage for errors and omissions, professional liability, media liability or product liability. Make sure that your financial statements are prepared on an accrual basis so that they provide an accurate picture of month-to-month activity. It's even better if your financial statements are periodically reviewed or audited by a CPA. If you've never had that done, you should give it serious consideration now.
On a daily basis, manage your firm in such a way that you are making it a more attractive target for a potential buyer. This means consciously building value within the firm. There are many different aspects to this:
- Client base
This includes the longevity of accounts and the average collection rate, the client categories that you specialize in, and the long-term trends in those client industries.
Are you focused on services for which there will continue to be strong demand?
- Key personnel
Have you put together a team with the right mix of skills and personalities? What is the strength of their commitment to the ongoing success of the firm?
- Marketing and sales
How do you promote your services and maintain a healthy workload? This involves good positioning and differentiation, as well as an effective marketing and sales process so that you are constantly identifying new opportunities and lining up new commitments.
What types of written contracts, leases and agreements have you signed? Are the terms and conditions favorable to your business? It's especially attractive to have long-term commitments from clients.
Are your prices competitive and have you factored in an adequate profit margin?
- Work methodology
Have you developed an appropriate process that enables you to produce great work? At the same time, is the process efficient and productive? Does it keep projects on schedule and on budget and does it prevent serious problems?
- Financial systems
Do you have reliable systems and procedures in place that provide accurate and timely information? Do you have controls in place to effectively manage costs?
Does your performance compare favorably to that of your peers on key indicators such as profitability and utilization?
- Cash flow
Does the business produce consistent, positive cash flow from operations, with no dramatic peaks or valleys?
- Equipment and technology
Do you have in place the full range of resources needed to produce great client work? In each category, do you have the newest and best? Do you have licensed copies of all software?
Are the physical facilities in a good location and in good condition? Do they create a positive impression on clients and project the right image for your firm?
- Intellectual property
Have you developed and retained ownership of any valuable intellectual property? This might include copyrights (such as illustrators and photographers who retain ownership of images), trademarks (especially for your own firm's name and visual identity), and perhaps design patents or utility patents (such as proprietary processes or custom coding developed by interactive design firms).
Is the general mood in the workplace positive and creative? Is staff morale high? Do team members look forward to coming to work each day? Is the company a place where the best and brightest want to work?
As you come closer to selling your firm, you will need help and guidance from a number of professional advisors. It's important to find the best that you can. Do some research and ask for recommendations. These advisors will include:
- A business accountant
Use a certified public accountant to review or audit your financial statements and to provide advice on tax issues. Your CPA should have experience with other firms in your industry.
- A transactional attorney
An attorney will be required for preparation of contracts and for ongoing guidance. He or she must have specific experience in the buying and selling businesses and in the negotiation of mergers and acquisitions (often referred to as “M&A”).
- A business broker
Your broker must be a specialist in your industry. When you list with a broker you may need to pay a retainer. The relationship may be either exclusive or non-exclusive. Most brokers receive a contingent fee that is scaled to the size of the transaction (often calculated in layers: 5% of the first million, 4% of the second, 3% of the third, 2% of the fourth, and 1% of the balance).
- An industry appraiser
Professional appraisers are industry-specific. Most charge a flat fee.
- A personal financial planner
You should use a private financial advisor to help you plan the best use of the proceeds from the sale.
- A lender
Eventually, there will also be a lender in the mix to provide financing for the buyer.
You will be guided through the valuation process by a professional appraiser. Usually he or she will calculate the value of the firm using several different methods, get a range of results, then determine a final value that is somewhere in the middle of the range. Here are some of the most common approaches (your CPA can provide you with more detailed explanations of the calculations involved):
- Net asset value and future revenue stream (ROI)
This focuses on the buyer's potential return on investment, adjusted for market demand as well as for operational and management factors.
- Capital asset pricing model (CAPM)
This approach values the firm by relating risk and expected return. Buyers will require additional expected return (called a risk premium) if they feel that additional risk is involved.
- Discounted cash-flow analysis (DCF)
This is a method of evaluating an investment by estimating the future cash flows that will be produced. (A variation of this method is called “capitalization of earnings.”) The calculation takes into consideration the time value of money (the idea that a dollar today is worth more than a dollar in the future, because the dollar received today can earn interest up until the time the future dollar is received).
The valuation process will include a comparison of your firm to others that provide the same kind of services, using several standard performance indicators. The market value of your firm may be stated as a multiple of one of these indicators:
- Earnings before interest and taxes (EBIT)
- Earnings before interest, taxes, depreciation and amortization (EBITDA)
- Adjusted profit (net profit + add-back amounts for any excess salaries and perks)
Each indicator will be calculated as a weighted average of the past three years. (As one example of this: in a strong economy, PR firms in hot categories have been known to sell for up to six times their average adjusted EBIT.)
Depending on the type of firm you have, there may also be a multiplier or rule of thumb that is based on annual sales, gross margin (or agency gross income, if you're involved in advertising), annual percentage growth in fee billings, or cash flow. Whenever a business is offered for sale, a search is done to identify any recent transactions that are in some way comparable. (For example, you may own an industrial design firm and your research may indicate that firms similar to yours in size have recently sold for between 1.0 and 1.4 times their annual revenue, or perhaps for between 4.3 and 5.0 times their annual profit.) Your valuation will of course be adjusted to reflect the specifics of your own situation.
An aspect of valuation that will vary quite a bit from firm to firm is business goodwill. Goodwill includes any intangible assets that provide your firm with a competitive advantage. These might be a strong brand, an excellent reputation, or high employee morale. These do not appear on the balance sheet of the firm being sold, but they will be included in the purchase price. After completion of the purchase, goodwill appears on the balance sheet of the acquirer as the amount by which the price paid exceeded the net tangible assets of the acquired company.
When you're ready, the next step in the process is to prepare a selling prospectus that will be given to business brokers and to qualified buyers. In scope, it's rather like a business plan, but it emphasizes the strength and quality of what's in place today. You need to put into writing everything that makes the firm successful. The contents will include:
- An overview of the company
(your history and reputation)
- A description of your services
- An overall market assessment
- An overview of your sales and marketing process
- Descriptions of any special assets, processes, or agreements
- Profiles of key management personnel
- A summary of financial performance for the past three
(this should be a top-level recap with enough information to show trends, but not complete details—they will be shared later in the process)
- A three-year projection of future financial performance
(project your current financial trends forward as realistically as possible)
- The company's ownership structure
(partnership, corporation, et cetera)
- Your asking price and preferred financing
Special issues for professional services
Selling a firm that provides professional services is very different from selling a company involved in manufacturing or retailing. To start with, there is a limited pool of buyers because they must have relevant professional experience. For a design firm, this means a proven ability to market creative services, produce excellent work and manage the creative process efficiently. Another difference is the fact that the long-term success of a professional services firm is very dependent on client loyalty. This involves maintaining a high level of trust, an excellent reputation, strong referrals, and personal bonds. Because of this emphasis on personal relationships, any change of ownership brings with it the potential for degradation of the practice. Great care must be taken with the planning and completion of a successful transition period from the founder to the new owner.
The timing of your sale will have a big impact on the selling price and the terms of the deal. The overall health of the economy is a factor: the level of optimism in the country will affect the availability of financing. Trends and cycles within your industry are important: if the industry is expanding, the perceived risk for potential buyers will be lower. Individual businesses go through cycles as well, so the current condition of your firm is important: are you expanding or have you recently been forced to cut back? If several different acquisition targets are available to a buyer, why would your company the best choice at this particular moment in time?
If you find yourself in the midst of an economic downturn, it's not a good time for you to sell. Buyers with cash will be looking for bargains. It's much smarter for you to use a downturn to make changes and improvements: fine-tune your internal systems, rethink your services and resources, perhaps even reposition or restructure your firm entirely. By doing this, you'll be prepared to benefit when economic conditions improve. Sellers tend to get the best deals early in an upswing.
Negotiating the deal
When you have your advisors in place, your business valuation completed, and your selling prospectus prepared, you're ready to start talking with potential buyers. Have each one sign a confidentiality agreement. You'll be revealing competitive information about your operations and you need to protect that information. Don't set any deadlines for yourself or expect things to move forward too quickly. The process of identifying a buyer and negotiating a deal often takes six months to a year. The exact structure of the deal will emerge from the negotiations and will reflect the advice that you receive from your professional advisors. Here are some of the basic options:
- A taxable purchase of assets
The deal may be structured as a taxable purchase of assets for cash and/or other considerations. The price paid by the buyer will be allocated over the various assets purchased, and those assets will be stepped up to fair market value.
- A taxable purchase of stock
The acquirer will make a taxable purchase of stock in your company for cash and/or other considerations.
- A tax-deferred exchange of assets for stock
This involves acquisition of the seller's assets in a tax-deferred exchange for stock in the buyer's company.
- A tax-deferred exchange of stock for stock
This involves acquisition of the company in a tax-deferred exchange of your stock for their stock. This pooling of interest merges the two business entities into one. All assets and liabilities will transfer to the buying company at book value.
Along the way, the deal will be fleshed out with many variables, including the amount of any down payment. If you negotiate a taxable purchase, the deal will consist of a mixture of some cash and some stock. You will need to receive enough cash to pay the taxes that will be assessed. For stock, you will face restrictions on the amount, timing and method of selling any shares that you receive. Details about the financing lined up by the buyer will also vary. Occasionally, discussions may touch upon the option of seller financing. I recommend against this because it offers less of a clean exit for the seller. However if you do take this route, it involves negotiating an interest rate and the length of the payment schedule. A promissory note must be prepared and signed, and you may want to require additional security to be given by the buyer.
All through the negotiating process, work closely with your CPA to manage the timing and amount of any tax liability. Sellers will usually want most of the deal taxed at a capital gain rate rather than a personal rate. Your CPA will also advise on different rules for “S” corporations and “C” corporations.
There are several other variables that could come up in your discussions. One of them might be the ownership of accounts receivable and work-in-process inventory. This is because they relate to work done by the departing owner. When client payments eventually come in for that past work, the buyer may be willing to pass the money through to the seller. However, it would also be logical to discuss responsibility for any open accounts payable that relate to those same projects. If the seller is entitled to receive the client payments, he or she should also be responsible for paying the vendors who were involved.
Real estate is sometimes an issue. Most design firms lease space. If a building was purchased at some point in the company's history, more often than not it was purchased separately by the owner of the firm, not by the design business itself. This means that if the business is later sold, the building will not be included in the deal. The previous owner of the business will remain in the picture as a landlord.
As you go through the negotiation process, it's important to identify and manage risks, both for the buyer and for the seller. Discuss what could go wrong and plan how to cope with each possibility. For example, what would happen if the deal fell through—who would be responsible for paying the advisers? Another example would be the major risk to the buyer of potential degradation of the practice after the purchase is complete. To mitigate this, the buyer will often negotiate an employment agreement with the seller to keep him or her on the payroll through a reasonable transition period, often three to five years. The agreement will include a good salary and an impressive job title. Beyond that, the buyer will want to motivate the seller to work hard to make the transition a big success. This is done by offering future incentives and contingent payments (often called “earn-outs”). Each deal will be different, but it's not unusual for 70% or 80% of the total value of the deal to be paid up-front, with the balance structured as earn-outs. Both parties will agree on the goals in advance. Your agreement must define precisely what the payments will be based on and how they will be calculated. This is important because the accounting system for the business may change after the acquisition and the format and terminology of reports may be different. Specific goals can be both annual and cumulative. You might also want to negotiate for higher payments to be made if the goals are exceeded.
One final negotiating point might be the name of firm. Will it retain the original name during the transition period? When will it change and what will the new name be?
Closing the deal
The process of finalizing the commitment starts with a letter of intent (sometimes called a “term sheet”). This is a non-binding summary from the buyer to the seller of all the major deal points that have been decided. Signing the letter of intent will initiate a period of “due diligence.” This is a pre-determined amount of time, usually several weeks, during which the potential buyer will have access to all of the company's books, records and files. They will investigate the information given to them so far to ensure that it's true and accurate. The potential buyer will exercise care in evaluating the company's operations, solvency, and the trustworthiness of management. As part of the process, they will interview employees and perhaps customers. During the due diligence period, it is mandatory for the seller to make any material disclosures, such as pending lawsuits. Material information includes anything that would influence or change the judgment of a reasonable person about the deal.
During this time, the potential buyer will review complete financial data for the past three to five years. They will use this information to prepare new projections of future activity that factor in any new savings or costs. For example, if the company will be run as a subsidiary or a division of the acquiring firm, it's possible that a monthly management fee will have to be paid to the parent company. This will be added into the projection of overhead expenses.
At the same time, however, the seller should conduct a reasonable investigation of the potential buyer. Verify the accuracy of the information that they have given to you and ask for any additional data that might help you to reach a sound business decision. If the buyer has purchased any other firms in the past, it's a very good idea for you to speak directly with those other acquisitions.
At the end of the due diligence period, it's time to sign the full purchase contract and complete the closing process. The full contract will include a covenant not to compete. The purpose of this is to prevent you from immediately setting up a new firm in direct competition with your old one. To emphasize the importance of the covenant not to compete, it will usually be allocated a portion of the purchase price. However, you will not want unreasonable restrictions placed on the future direction of your career. Because of this, the covenant not to compete must be very specific in activity, place and time.
In some industries, buyers will sometimes make one final request before signing the purchase contract. They may ask for an interim “management agreement.” This is essentially a test drive. It allows the potential purchaser to manage the company for a while before actually buying it. This would be unusual for a design firm and you should definitely say no. There is too much potential for damage to the business. The purchase could later fall through and you would be left to pick up the pieces.
OK, the deal is done. Now you must make sure that the transition period is successful. There are many inhibitors of change that might come into play, so you should expect some turbulence. Chances are that your staff will feel insecure. They may be resistant to new procedures, even worried about the future of their own jobs. It's smart for the new owner to motivate the staff, particularly key managers, with financial incentives tied to important business goals. In mergers and acquisitions that involve large firms, some common threats to success include lack of clarity about the desired outcome, culture clashes between the two organizations, conflicting interests and the emergence of competing factions.
You must work had to transfer customer loyalty to the new owner. Meet individually with clients to emphasize the benefits of the change. Maintain as much continuity as possible within individual account teams and continue to provide outstanding customer service.
Plan and execute a comprehensive public relations campaign. A typical time span for the campaign would be eight to ten months. It's especially important to explain the change and communicate a positive message to the market if the business now has a different name—you don't want people to think that the company simply went out of business.
Finally, for the seller, there may be emotional issues related to letting go of the old and embracing the new. It's not unusual for the founder of a firm to experience “seller's remorse” when he or she moves on. This is particularly true if your self-identity has been very tied up with the firm. Directing projects has put you in control, given you access to important people and won accolades. It may be hard to step out of the spotlight, to give up authority and perhaps even the sense of being needed. All of this will be psychologically much easier for you if you've used the business transition period to define yourself apart from the office and to prepare for your next personal move.
About the Author: <p>Shel Perkins is a graphic designer, management consultant and educator with more than twenty years of experience in managing the operations of leading design firms in the U.S. and the U.K. He has served on the national boards of AIGA and the Association of Professional Design Firms. He has been honored as an AIGA Fellow "in recognition of significant personal and professional contributions to raising the standards of excellence within the design community." The third edition of his best-selling book, <em>Talent Is Not Enough: Business Secrets For Designers</em>, is available from New Riders. </p>