When to Exit or How to Succeed in Succession Planning

For more than five years, analysts have been anticipating a flood of business owners exiting their enterprises. According to a 2012 Canadian Federation of Independent Business (CFIB) study, close to half of small- to medium-sized enterprise (SME) owners planned to exit their business by 2017; a dramatic increase from the 2006 CFIB survey when one-third of businesses were in the same position.

Another study shows similar statistics: 6 in 10 private companies in Canada were expected to change ownership structures within the next decade, according to a CICA/RBC Business Monitor Survey, 2010. Despite those promising figures, there has been an underwhelming absence of actual buy and sell activities among SMEs .

 70 is the New 65

According to Industry Canada, baby boomers accounted for approximately 70 percent of SME business owners in 2004. In 2010, more than 60 percent of SMEs were controlled by an owner aged 50 or older; thus, the number of business owners seeking an exit option is very likely to increase in the near future.

The lack of anticipated business transitions could be attributed to several issues, including:

• The economic downturn of 2008-09:  the downturn delayed the exit date of many SME owners, as their personal RRSP / investment portfolios were hit, business valuations fell and lending was tougher to access;
• Poor understanding: SME owners are not clear on how to begin the process of transitioning their businesses. People generally know how to sell a house; but selling a business is a much more complex process.
• Problems choosing a successor: business owners struggle to identify successors who will maintain the legacy of the business and the culture. In many cases, the business owner has operated the business for 20 plus years; transitioning such a business can give rise to protective sentiments akin to those felt when considering an appropriate spouse for your offspring.  
• Unrealistic expectation: understanding what the business is worth and knowing what to do after retirement / the sale of the business can be a challenge. Some owners will confuse what they need to retire vs. what the business is worth. It is important to have realistic expectations of the value of a business.

While businesses are changing hands quietly and confidentially via transitions to family members, management buyouts and private company transactions, the level of transactions has not neared the flood level … yet. Data indicates a mass transition of businesses should be occurring in the next few years.

Buyers Outnumber Sellers

One point is clear: there are more potential buyers than sellers for profitable SME businesses that are able to transition to a new owner. Buyers include:

• Entrepreneurs wanting a business they can run, rather than being an employee;
• Businesses looking to grow or diversify via acquisition; and
• Private equity groups seeking investment opportunities for businesses they can actively manage, as opposed to public stock market investments. Further, private equity groups are moving down market by seeking smaller companies to acquire, as there is a dwindling amount of larger companies available.

The current level of buy-side demand should be considered in the decision of when to sell, as it is not likely to continue in the long term.

When will the number of sellers begin to outnumber the buyers? When is the tipping point?

Currently, the market isn't saturated with SME business for sale. But this will shift over time, as many expect that the market will overcorrect and become saturated.

What are my exit options?

Business owners need to transition their business in some form, at some point. There are four real options to exit:

1. Winding up the business is not an attractive alternative in most cases. Drastic events, such as health issues or death aside, proper planning should mitigate the need to wind up a business.

2. Transitioning to family members happens, but it is less common. Fewer family members are stepping up to continue the family business. Generally, the children of baby boomers are less likely to take over the family business and they face less pressure from their parents to do so. Only one-third of family businesses are successfully transferred to the next generation, according to Family Firm Institute, and a mere 13 percent are passed on to the third generation.

3. Transitioning to a management team is a good, viable option for many companies. A few factors are key to a successful management buy-out :

• The business has to be big enough to employ a capable management team;
• The knowledge and relationships should be shared with the management team;
• Management should purchase as much as is feasible to have 'skin in the game.'

4. Sell to an outside party. The greatest number of buyers exists within the outside party group which includes entrepreneurs, other companies and private equity groups. For owners, selling to an outside party is a feasible and attractive alternative for quality businesses. Some owners will consider partial sale options that allow them to retain some ownership during a transition period (this can be an easier pill to swallow than simply handing their 'child' over).

There is a potential downside to the expected course of events over the next several years: the increased supply of SME businesses available might lead to a dramatic increase in companies for sale, which would likely drive down valuations and give new leverage to buyers.

Succession Planning is a Process

Business owners are generally responsible, organized and forward-looking people; planning for the succession of their business should be high on their list of things to do. However, according to a 2012 CFIB survey, less than 10 percent of SME owners have a formalized business succession plan.

It is important to plan the transition process. An effective succession plan is put in place one-to-five years before the eventual transition of ownership. It is too late to capture value or appropriately plan when a significant health issue or significant business issue occurs.

Each transaction and business valuation is unique. Having good advisors can simplify the process and help ensure your future looks like what you plan.

For more information, contact Craig Maloney, Managing Director, Corporate Finance, at 902.835.7333 or [email protected]