Ideas for Money

Once you have agreed to the ground rules in principle, the next step is to draw up a merger agreement, and a shareholders’ or partnership agreement. It is possible to combine these two agreements into one.

The merger agreement

The merger agreement will address the commercial aspects of the merger, including: What assets from each business are being merged? Into what sort of business entity, for example partnership or company? What is the value of these assets? What will be the shareholding in the merged entity? If shareholding is to be 50:50, and if the respective business assets are not equal in value, how and when will the equity-balancing amount be paid? What duties for what monetary return, (e.g. salaries, commission splits, dividends, etc.) will the owners undertake? What is the company’s policy to be on such things as motor vehicles, business expenses, entertainment, and so on?

For retiring owners, the shareholders’ agreement covers the second stage of their exit plan, namely agreement to buy the balance of their equity. However, the agreement should also govern the circumstances that might lead to the termination of the arrangements between the co-owners and/or the break up of the merged business, and what will happen to the ownership of the shares or interests in these circumstances.

If your initial meeting with any particular potential merger partner has gone well, you should now move on to the next stage of establishing the ground rules for the merger with this potential partner. These ground rules include:

Establishing the respective values of the businesses. Deciding the structure of the merged entity, i.e. partnership or
company? Agreeing the proposed shareholding in the merged entity. There are at least two ways of approaching this.

a) The first is to allocate shares strictly on the basis of the respective value of the two businesses. For example, assuming the merged business is a company, if business A is valued at £200000 and business B is valued at £400000, the total value of the merged company is £600000 and A’s owner will be allocated one third of the shares in the merged company and B’s owner will be allocated two thirds of the shares in the merged company.

b) The other possibility is that the owners will wish to be equal shareholders from the beginning. This will only work where the acquiring partner has the smaller business, because the retiring owner will not wish to expend cash and increase his business equity relatively close to retirement. The acquiring partner will pay the retiring partner the amount necessary to bring their shareholding to 50% each. This payment is known as the ‘equity balancing payment’ and when made, represents the first stage of the retiring agent’s exit plan.

As the retiring owner wishing to arrange a small business merger, the first thing you need to do is to confirm that your principal allows such transactions. Once cleared with the principal, locate a younger owner in the same franchise or agency group who is interested in growth through acquisition. Your principal should be able to assist you with this.

Once you have found suitable candidates, you should hold an initial meeting with each of them to explore the possibilities of a merger. These meetings should be informal, although formal undertakings of confidentiality should be exchanged. You should be open about your plans to merge and exchange enough business information to enable both parties to form an initial opinion on the possibilities and opportunities a merger might present. To establish your respective strengths and weaknesses, an informal SWOT analysis of the two businesses could be useful.

I will now examine in some detail the reasons why a merger could be a useful exit option for franchisees and licensees. Please note that I am talking here about a merger between two very small businesses (often owned and run by a single person with a very small backup staff). These mergers are sometimes known as ‘sole trader mergers’.

The ingredients of a successful small business merger

A small business merger is often conducted in two stages: the first stage is a merger between the two businesses (with both owners remaining in the combined business), whilst the second stage involves the older owner selling his equity (or the balance of his equity) to the merger partner and, thus, effecting an exit.

business owner (for example a franchisee or licensee) who is planning to exit his business within ten years, who we will call the ‘retiring owner’, although he or she might wish to exit the business for reasons other than retirement.

A second sole trader from the same industry, or profession who is at least five to ten years younger than the retiring owner, who we will call the ‘acquiring owner’.

The owners should be personally compatible and have a similar philosophy on the way they do business. The acquiring owner must be planning to grow his business, and must believe that acquisition through a merger is a viable growth option.

Both owners must have a realistic opinion of the fair (or true) market value of their businesses. The retiring owner’s business should be of a similar size to, or bigger than, the acquiring owner’s business. (Where the retiring owner’s business is considerably smaller than the acquiring owner’s business, a straight trade sale might be a simpler option for both parties.)

Both owners must be confident of the mutual long-term benefits of the proposed merger. The acquiring owner must be comfortable with working with the retiring owner for some time after the merger.

I have mentioned that purchasers will wish to acquire businesses that can be managed without the owner and that the best way to achieve this is to have a layer of competent management in place by the time of your sale. Unfortunately, although the first part of this statement will usually hold true (unless the owner’s plan is to stay on indefinitely as an employee and this coincides with the purchaser’s wishes), the second part might not.

Some purchasers desire to acquire businesses where they will put in their own management and, therefore, do not wish to acquire senior (or even middle) management employees. Having such management in place could, paradoxically, itself be an impediment for these particular purchasers. A solution to this is to know your potential buyers and to tailor your business to suit. In practice, of course, it might be very difficult to know exactly who your purchaser will be, but you could anticipate the type o purchasers who could be interested. For example, will they be trade buyers from your industry (you might already have had informal talks about selling with some of them) or, perhaps, venture capitalists? What are their different requirements likely to be?

The management required to run a business will vary not only with the size of the business, but also with the type of business. This is relevant to exit planning because on disposal a business can: change from being one type of business to another. For example, from a private company to a public one; change in the type of management. For example, from a single owner-managed business to a business owned by its former management team, or from an owner-managed business with branch managers to a franchise organisation.

Different types of business require different types of management and exit planning requires that a business be positioned for this transition. For example, one of differences between a franchise business and a nonfranchise business is that in a franchise the franchisor supplies a level of management expertise (on such things as buying, training and operating procedures) to the franchisee that a non-franchise business has to provide for itself. Also, the type of person suitable for branch management might not make a good franchisee.

Another example is where a company goes public. An issue that now arises is whether the company’s management will be considered suitable to run a public company. This perceived suitability might not be restricted to pure operating management ability, but could include such things as personal standing and reputation in the business community.

As a final example, if your exit plan is to dispose of your business to your management (through a management buyout), the managers will probably need to satisfy their financial backers that they are not only adequate for their respective management tasks, but also that, as a team, they meet the financier’s requirements of being suitably equipped for ownership.

The answer to the problem of the owner being the business is for the owner to work steadily towards replacing himself as the manager of the business, to make the business independent of him, so that when he goes on holiday the management do not even notice that he is away!

It is more likely that a business will grow and prosper in the long run if an owner ‘works on and not w’ the business, as the saying goes. However, what I am talking about here is the added value of a business on exit if an owner can make himself virtually redundant some time before he intends to sell, even if the short-term management costs are higher than is strictly necessary. (Note, when analysing ‘real profits’ of the business being sold, potential purchasers will take note that there has been some doubling up of management costs, which the purchaser will avoid if he is to manage the business himself.)

Where the owner has a layer of senior and/or middle management capable of running the business, the important point is to ensure that they remain in place when he comes to sell. Locking in key staff is a vital issue for all businesses and is brought into closer relief when the time of exit approaches. I will not examine here the general issue of how key staff can be locked into a business, as I address this issue in some detail later in postson Business Continuity Planning. I do, however, later plan to look briefly at the potential difficulties that could arise with your exit planning when you use share options as a motivating and retention device.

(Note: Where owners employ key staff, the cost effectiveness of keyman insurance should be examined, regardless of the mechanisms you have in place to try to ensure management continuity, because having the cash resources to fill management gaps could be very useful.)

Consider for a moment the consequences of this sort of business from the perspective of the owner wishing to sell. Most owners wish to depart the business on, or shortly after, the sale. The purchaser, however, needs to be reassured that the business will continue to operate on, at least, the level of turnover and profit it had achieved prior to the purchase. Where the owner is the business there must be extreme risk that this will not happen unless he stays on as long as is necessary after sale to transfer his business ‘know how’ to the new owner. Unfortunately, even with an extended handover there are still risks involved. What happens, for example, if the owner should die just after sale? What happens if he is incapable of transferring his knowledge to the new owner? And, what happens if the old owner is unable (because, for example, of critical illness) to take part in an extended handover?

Whilst ‘the owner is the business’ does not necessarily always lead to the business not being sold, it will almost certainly restrict the market of potential buyers. These will be other owner managers with similar industry knowledge and technical background to the seller, or investors who have a suitably qualified management team they can put into the
business. The other very important outcome wiil probably be a reduction in the price the owner was hoping to receive. Where the problem is real for purchasers they will insist on a price reduction to compensate for the difficulties they will have in running the business. Where it is not real, they will still use the apparent impediment s a bargaining weapon to negotiate down the price. Unfortunately, where the owner is the business he is on the back foot from the start of negotiations.

I first got involved with exit planning when I ran a mergers and acquisitions business in Australia. Many business owners would consult me about selling their businesses, although it was obvious that they were not fit to be sold, because of one or more impediments to sale (that is, reasons why the businesses would not fetch their asking prices). I would urge them to get advice on how they should best prepare their businesses for disposal and then return to me (after two or three years, if necessary) once the impediments had been removed and the business was ready for sale. When it became obvious that there were very few places that the business owners could obtain specialist exit planning advice, I decided to go into the exit planning advice business myself.

The real reason for this bit of background is to focus on the question of impediments to sale. Leaving aside that the  most common impediment to sale I encountered was the over-inflated view owners had of the value of their businesses (a view not confined to Australian small business owners!), the next most common impediment was ‘the owner was the business’. In other words, the owner ran, managed, drove and nurtured the business. He alone knew all the major clients and suppliers, understood how the factory was programmed and had all the management operating procedures in his head.

These businesses had no management. Certainly, they had employees, and often loyal and capable ones too, but none of them alone or together could run the business while the owner was away – a point emphasised by the fact that in most of them the owner had to telephone in every two days even when he was on holiday. The key question a hard-nosed purchaser would ask these owners in negotiations was: ‘What have you got to sell?’

Assuming that you do own your franchise business, the next question that arises is does it have a value that you can realise on exit? The franchise agreement should cover the ways you are able to dispose of your business, how it is to be valued on sale and the conditions that need to be fulfilled by you, the franchisee, and the prospective purchaser before you can sell.

The market value of the franchisee business might also be influenced by the agreement, because it could dictate that the franchisee is selling in a market controlled by the franchisor, rather than in one that is free. This could depress the business’s sale value. On the other hand, there could be positive factors in the agreement, such as if the franchisor offers to provide funding to purchasers, or itself offers to buy the business if the franchisee cannot dispose of it through  normal channels.

If you are a franchisee, the first exit planning step is to check what your agreement says about your principal’s policy on exits. A well thought-out exit policy will not only include some restrictions on disposal, but should also include guidance and help for franchisees on the how to go about a sale or succession and, perhaps, provide for the granting of loans by the principal on favourable terms to purchasers.