Boomers with Businesses...Developing an Exit Strategy

A manufacturing client in the Midwest, with revenues in excess of $5 million, asked for assistance in developing an exit strategy with a target date of 2011. The first generation owner had a son and daughter, both in the business. The owner was aware of the statistics that showed 1-in-3 private companies succeed through the second generation and 1-in-10 succeed through the third generation. He did not want to jeopardize his retirement based on an earnout agreement, so he hired us to assist him in developing an exit strategy favorable to all family members.

Candid discussions with the owner, the owner’s financial planner and a survey of potential buyers provided the information used to develop the plan. The strategy consisted of three elements:
1. Ensure the company has a leadership team that will continue to perform after transfer of ownership.
2. Develop a potential source of financing without engaging in a stock deal, earnout agreement or extended payments.
3. Capture sweat equity value on an annual basis rather than relying on it to be there on the date of sale.

How We Did It
There are a limited number of ways to separate the owner from the business; The owner can sell it, transfer it to the next generation, turn it into an ESOP, or take it public.

ESOPs work but are complex and expensive and taking it public was not an option. The owner wanted tactics that would provide the flexibility to either sell outright or transfer to the children. This flexibility required a strong and focused management team and a loyal and dedicated workforce.

To develop a strong and focused management team we customized a deferred incentive compensation plan for them. We used a design called LeaderShare®, specifically designed for closely held companies. Working with the owner and financial advisor, we developed a 5 year revenue and profit plan. This became the company vision for profitable growth. A deferred wealth building mechanism was established that rewarded the participants for performance toward the plan. The annual targets were adjustable to cope with the unforeseen changes but the ten year objective was considered realistic by all involved. It was the first time the management team had considered what the company might look like in the long term and everyone found it an exciting experience.

This tactic acted to retain and focus the leadership team. In keeping with the owner’s desire for flexibility, it provided the option of financing a management buyout. The option to overlay another LeaderShare® plan in years six through ten provided a strong retention mechanism for the management team should ownership transfer to the children. (The owner and children also participated in the plan, thus providing them with access to the value of the company as it accrued.)

Funding
The plan established a predictability of future earning and the financial planner used this projection to develop tactics for funding the deferred payout. He addressed the risk management element with term insurance on the owner and each plan participant. He developed an investment program that emphasized strong performance in a portfolio while maintaining low turnover. Because the portfolio was owned by the business, capital gains would be taxed at 20%, dividends at 8% and any interest payments would receive a low tax rate.

All that remained was to establish a process that would develop a loyal and dedicated workforce. To accomplish this we customized a cash incentive pay plan for them. We used a design called ScoreCard™, because of it’s ability to measure financial and operational performance on the front line level.

With funding, a leadership team and a dedicated workforce, the value and desirability of the company would be assured. Even if a buyer could not be found, the owner would have the flexibility of disengaging from the day-to-day business while continuing to receive a revenue stream.

Boomers With Businesses...And No Exit Strategy

An exit strategy is an owner’s plan for cashing out of the business he/she worked so hard to develop. All too often the owner is too busy managing the business to develop and implement an exit strategy.

So what will the marketplace look like in 2012, when boomers start to sell their businesses and retire? The data indicates it will be a buyers market with an excess supply of businesses and a limited demand. Why? Because 80% of the companies in the U.S. are privately held and there are 87 million baby boomers who will reach retirement age in 10 years. That’s a lot of business owners wanting to retire. The market will be flooded and buyers will be able to pick and choose.

What will make a business attractive to the limited pool of potential buyers? The same two things that make it attractive today.
1. The buyer must want it; it must be desirable in terms of profit, cash flow, management team and workforce.
2. The buyer must be able to afford it; capital to finance the deal must be available. (Even in today’s rather evenly balanced market, lack of capital is the cause of a high number of failed transactions.)

Experience shows that most of these boomer business owners do not have an exit strategy in place. The unspoken expectation of an owner without an exit strategy is that the business has value and the value will be realized at the time of sale. Early in my career, a friend who was building a construction business told me “The nice thing about owning a business is not the paycheck but the fact that you are building wealth for your retirement.”

Yes, that is true, but ONLY IF YOU CAN SELL IT. Often there is a disappointing gap between what the owner thinks the company is worth (sweat equity value,) what the market says it is worth (market value,) and what the assets are worth (book value.) The time of sale is the worst possible time to seek the value in the business.

In order to avoid disappointment when it comes time to sell the company, smart business owners develop an exit strategy that includes tactics for tapping the value of the company over time, and making themselves obsolete, i.e. building an organization that will perform well without them.

Such a strategy requires time to mature and come to fruition, somewhere on the order of 4 to 6 years. That means boomer business owners need to implement an exit strategy today!

Stay tuned for information on how to develop an exit strategy.

Changing Face of Exec. Pay: Case History

Performance Performance Unit plans are gaining traction in industries ranging from manufacturing to service and from dot.com to retail. Boards and stockholders like this plan because it creates a dynamic tension between achieving short-term results and long-term outcomes. Participants are required to understand the business, maximize the ROI of available resources, think strategically and act tactically. Exceptional performance delivers exceptional wealth. Average performance may result in minimal deferred compensation, if any.

Owners of closely held companies like this plan because it is a low risk approach that enables them to compete for the best talent in the marketplace. And, it provides the foundation of an exit strategy.

A modified version of this plan was developed for a client in the manufacturing sector. The privately held company needed a top notch marketing executive to capture the marketplace growth potential. The owner’s exit strategy was to sell the company in seven years. To that end, he was committed to maximizing the value of the company in terms of EBITDA and market multiplier. The marketing executive was an essential element in this plan.

The challenge was to develop a pay package that would attract someone at the top of their game to a small Midwestern city, for a private company that would be sold in the near future.

The solution was to offer a pay package that matched the business opportunity. A combination of base and incentive pay was set at the 85th percentile of the market. The deferred incentive compensation element was designed to reward the increase in asset value. By using a modified Performance Unit design it was possible to share the increase in value without changing the company’s capital structure.

In this design, units are earned annually and represent a right against ownership (RAO™). Unlike traditional performance units, RAOs are not cash equivalents. Instead, they represent a percent of the market value. The design encourages the leadership team to improve net profit, reduce debt and polish up the company’s market appeal to increase the value modifier at time of sale.

Compensation is an evolving discipline. Stock options have shown us there is no free lunch when it comes to pay. Compensation is a cost. But it is also an investment and we are now at the point where compensation professionals are beginning to emphasize pay systems that reward Return on Investment.

The Changing Face of Executive Pay: Performance Unit Plans

Your company had to restate its earnings (downward) for the past several years. Your senior management received incentive pay based on those earnings. Will you be able to recover that incentive pay? If so, how? If not, how will you explain it to the board and stockholders?

Your company’s deferred compensation plan allows participants to select the type and timing of deferments and payments. They make an inappropriate selection and, due to a recently enacted law, trigger a taxable event for themselves.

Boards are being held legally accountable for the corporate actions and, as a result, are keen to put a stop to option abuse, re-pricing and the unpleasant effect that overhang and dilution have on the reported company value.

Executive compensation is under siege and compensation professionals are being pressed hard to respond.

Taxes: On October 11, 2004, Congress passed the American Jobs Creation Act (JOBS). JOBS added Code 409A to the IRS code. 409A changes the tax rules affecting nonqualified deferred compensation. The changes restrict flexibility, place limits on timing, limit security techniques and limit distribution options. Code 409A will require those with deferred compensation plans to amend most arrangements and terminate some. This code reduces the flexibility of deferred compensation plans. Failure to comply with the code will automatically trigger a taxable event, in come cases for all of the participants in the plan!

Stock options: New reporting rules took effect in June, 2005. They require stock options to be reported as an expense on a company’s financial statements. This, along with the problems of “under water” option values, re-pricing, and high profile abuses have made boards much more conservative in the use of options. America’s largest companies are waving the white flag. The February 28 issue of BusinessWeek reports that nearly two thirds of America’s 200 largest companies have cut back their use of options. Also being discontinued are the use of mega-grants worth more than $10 million and ‘evergreen’ provisions that replace options as they are exercised.

Deferred compensation is an essential part of a pay package designed to attract, retain and motivate the leadership team. Many companies are taking this opportunity to refocus their executive compensation philosophy and include a component that emphasizes internal value.

While not entirely eliminating stock options, these companies are adopting Performance Unit Plans that provide executives with stability to their pay portfolios while ensuring the company receives the agreed-upon ROI.

A Performance Unit Plan is a form of non-qualified, deferred, incentive pay that avoids the problems associated with stock options and is Code 409A friendly. These plans focus on controllable business outcomes and, as such, are effective at attracting, retaining and motivating executives who want a share of the increase in value they create.

With a Performance Unit Plan, performance is guaranteed to build personal wealth. Participants who can’t perform or who are uncomfortable with focused accountability will deselect themselves and go looking for greener (easier) pastures...exactly the results we want in a good retention mechanism.

The objective of a properly designed Performance Unit Plan is to increase asset value by generating profitable growth. It’s linked to internal measures and rewards good performance no matter how the stock market performs.

Performance Units are earned for short-term results and appreciate in value as the value of the company increases. Executives must achieve both short and long-term objectives to maximize their rewards. The appreciation element uses a simple valuation process based on improvement in the ability to create profit. Here’s an overview of the components:
Performance unit: Cash equivalent certificates, earned annually, and based on performance toward annual objectives. These units vest over time.
Increase value: A target increase in the company’s ability to generate profit is established at the beginning of the plan period. Each participant knows, in advance, the wealth they will receive if the company performs at target. Attainment of this target results in the payout of a predefined amount to each participant. (If we reach ‘X’, you receive Y’.)
Appreciation: A well designed Performance Unit plan is not an all-or-nothing plan. During the plan period, performance units have the potential to appreciate as profitable growth moves toward target. The amount of appreciation is a function of the executive team’s ability to successfully anticipate and plan for future business opportunities while maximizing the current return on available resources.

Stay Tuned for a Case History.

Employees as Business Partners

“We do it because it makes more money.” Bob Frye, CEO, Cin-Made.

I often ask employees “What is the purpose of a business?” Normally, very few answer “A business is a money making machine.” Partners and owners, on the other hand, rarely miss this answer. How then, can a business owner develop the same level of understanding among employees?

Research indicates owners/partners have four key distinctions that set them apart from traditional employees. They are Educated, Enabled, Empowered, and Engaged. Because of this, they are confident in their assessment of situations and their ability to solve problems. This allows them to improve the operation through their own initiatives. To have all employees perform in this manner it is necessary to develop their capabilities in these four key areas.

Education: Line-of-Sight and a Personal Action List
In the business of making money, progress (or lack of it) is kept score using an income statement and balance sheet. Owners/partners understand how to read these scorecards and understand what circumstances created the numbers. Educating all employees to understand these documents can be achieved during a half day workshop that addresses the issues of revenue, expense, profit and cash.
It’s much more difficult to help them understand how their daily activities impact these numbers. I find this “line-of-sight” easiest to develop in small work groups, where employees identify the line items they contribute to and define the operational measures (productivity, quality, scrap, attendance, etc.) that affect those line items. Part of this education is an understanding of the work flow process. With this education everyone understands how an improved process contributes to profitability.
The final step in this education is for each employee to internalize their understanding by creating a list of personal actions that will improve the numbers.

Enable
Educating employees without providing them with the tools to take action is wasted effort. In order to turn knowledge into results, employees must have access to business information on a timely basis. One proven approach is weekly team or department meetings where the appropriate measures are shared and discussed.
Organizational systems, such as self-directed work groups, problem solving teams and suggestion programs enable employees to participate and contribute. Training in problem solving, decision making, process analysis and interpersonal skills enable employees to use their operational measures to ensure the processes work well and to improve their personal performance.

Empower
For employees to act like partners they need the authority to take action. Perhaps the biggest difficulty an owner has is to release the authority to take action without unleashing anarchy and chaos. One successful approach to developing this empowerment is to release authority to act based on demonstrated performance. This authority is situational in nature and extends only to the degree an employee has demonstrated competency. The process is: 1.) identify an area of improvement, 2.) share knowledge, 3.) provide clear direction, 4.) observe performance, 5.) review results and learn from experience, 6.) release situational authority to take action based on demonstrated competence.

Engage
In order to engage the employees in the business to the same degree that owners or partners are engaged, everyone must be provided with a reason to be interested, to participate and to improve the situation. Because this partnership process personalizes work, it becomes more meaningful and, in doing so, increases employee satisfaction and self-worth. However, the most successful organizations provide everyone with a reason to be interested in the profits. They use incentive pay systems, with rewards linked to results, to share the gains of improvement with those who help make them, thus developing a sense of common destiny and a true partnership with all employees.

The Secret of Success: Managing Expectations
Success in creating a business partnership with employees depends on the strength of leadership. Leadership must set the expectation that “We are going to become a measurement driven company.” They must set the expectations that each employee will be educated in the key measures of the company and the specific numbers of their department and that each employee will be expected to track and understand the numbers that are important to them. They must set a timeline of expectations (“this will take five years”) and a plan of action (“we will do it step-by-step, in weekly meetings.) Lastly, they must define the benefits of participation and establish the consequences of not participating.

"In business there is no order, only managed chaos. Those with the best information, understanding and motivation will manage it the best." T. J. McCoy.

Innovation as a Competitive Advantage: Part 2

Dave’s company was experiencing competitive and pricing pressures and he wanted to get all employees pulling in the same direction. As a way of creating focus he developed the motto; “Unmatched service in all we do.” He knew in order to deliver on that motto, he would have to develop employees who were innovative, who would initiate change in the established way of doing things. His only concern was that the business might spin out of control as everyone changed “the way we have always done it.”

Dave called me and asked for help solving his problem. I provided the experience and research and together we built a model we could use to develop an innovative workforce.

First, we examined the workplace cultures of companies known for their innovation. We found their employees had four things in common. They had:
1. Understanding
2. Ability
3. Authority
4. A Reason

We assumed, rightly so as it turned out, we could encourage an innovative environment if we introduced these elements into the workplace. Here is how we did it.

Understanding: The research showed that in order for employees to become innovative they must understand the objectives of the company. We found it was important to educate them about the industry, the company’s target market, products, business plan and competitive pressures that affect the plan. We learned that innovative employees need to know about the customers, their needs, and what expectations were developed by the company’s marketing promise. Only then could they begin to think about how they contribute to company success. We also found that it was important to share performance information on a timely basis, to communicate about the ongoing business situation and how well the company was performing against business plan.

We concluded that information and understanding are the raw material from which new ideas are created. As part of our research we found support for this conclusion as far back as the 1880s. Reme de Gourmont, a turn-of-the-century writer and philosopher observed “You can’t possibly get ideas if your mind is bound up by associations. One needs to become disassociated from current circumstances in order to get ideas.” For us as managers this meant “distracting” employees from the micro focus of the daily details of their jobs by providing them with new information about other, bigger picture aspects of the company and the customers.

So we developed an education and information sharing campaign. It wasn’t difficult. We didn’t open the books and expose the financial statements. Instead we conducted a communications audit to identify the information each group needed. We stopped providing unneeded information and started providing information that would enable each group to expand their thinking.

Ability. We also learned it was necessary to establish a system within the workplace that enabled the employees to participate in the business. Most companies are organized to control the workforce. This management style inhibits employees from making changes and discourages innovative thinking. In order to stimulate innovation it would be necessary to develop a system that provides employees with the ability to make changes, to turn ideas into action.

Dave was understandably reluctant to turn loose the reins of control until the employees demonstrated they understood the effect of their actions on the bottom line. So we started with a small step. We developed “Idea Teams.”

These teams were voluntary groups of employees who agreed on the need to change and had an idea how to improve a process or procedure or for a new product or service. We provided them with initial training on how to conduct a productive meeting and the criteria required for successful implementation of change. Initially, the criteria was focused on revenue, cost and customer satisfaction. Armed with this knowledge and information the teams would meet to discuss their ideas. Once they defined the benefits of the idea and documented the cost of change they would present it to the senior management team for final review and approval.

Authority. Dave first announced the concept of innovation in an all-hands meeting. He provided a compelling reason for change and described the Idea Teams program. We were aware that, initially, employees may be reluctant to engage in this new behavior. So during the meeting he clearly stated his desire for an innovative workforce. In doing so, he provided them with the authority to participate, request information, gather as a group, and question the status-quo.

A Reason. Having considerable experience with the development and implementation of employee involvement plans, I knew the importance of providing a reason for employees to participate. As part of the plan we included an opportunity to earn incentive pay. Team members would receive 50% of the first year’s net savings for every approved idea. This not only encouraged participation but also ensured that profit-building ideas were implemented first.

Dave’s company now has over 50% of the workforce participating on Idea Teams. The company has grown in revenues and profitability. Employee turnover has declined and market share has increased. The company has become more responsive to the marketplace and the customer. According to Dave, “My employees are beginning to embrace change because it makes their work more interesting and they have a process they can use to manage and control it.”

Is Dave’s company like 3M when it comes to innovation? Not yet. But they are on their way. They have taken the first step toward building a culture of partnership, where each employee thinks and acts like a business partner. You can do it too. Getting started is as simple as 1, 2, 3, 4.

Innovation as a Competitive Advantage: Part 1

Thinking of growing your business? The other day I spoke with a business owner about her plans for the future. Her company currently generates $3.5 million in revenues and I asked how much revenue she planned to generate in 5 years. The response alarmed me. “About the same,” She said, “Maybe 4 million.” Well, that presents an interesting problem because we all know there is no standing still in business. Over time a company either grows or declines, but rarely holds steady.

How do you plan to grow your business? Through acquisition? Price reduction? Through “value added” services or head-to-head competition? Each of these traditional growth strategies has inherent problems, many of which are cannot be easily resolved.

There is another strategy. It’s called innovation. It’s the growth strategy of the new millennium. Innovation provides such a competitive edge that the European Union has created a commission to foster “the innovative culture.” It promotes innovation at the community level, supporting European business to innovate, develop and market new technologies. These are the folks that are competing for your business.

Not to worry, “American business is known for it’s innovation.” Perhaps as a nation we are, but does that statement apply to your company? Is innovation your competitive edge? What’s that you say? In your industry innovation means expensive hardware and software that becomes outdated in a few years? How can you justify the cost of innovation?

We’re not talking about that type of innovation. Lets take a moment to clarify what we mean when we refer to innovation. The definition found in the Random House Dictionary of the English Language is: “To introduce something new.” “To make change in anything established.”

According to this definition, innovation is more of a process than a purchase. It has more to do with people than with assets. At least this is the way companies like 3M view innovation. It is not only about new products and services but, perhaps more importantly, about new ways of performing the day-to-day activities. The owner of a Midwestern company with a regional market (we’ll call him Dave) had the following observation, “It’s not about making another capital investment. It’s about improving the return on my current investment in human resources.”

Stay tuned for Part 2.