Which Way to the Exit?
Agency owners thinking about selling or succession should first know and weigh all their options.
No matter what conference you attend in the ad/PR industry, there is invariably buzz at the cocktail hour about the latest M&A deal. “Did you hear that ABC Digital just sold to MegaWorldwide?” goes the conversation. “Yes—and I heard they got a multiple of 7,” is a typical retort of an envious listener, envisioning the founder of ABC Digital walking away from her firm with a wheelbarrow full of money.
Indeed, owners unfamiliar with the seemingly mysterious inner workings of M&A deals, or whose knowledge is limited to what one M&A guru had to say on the topic at the conference, could easily come away thinking that selling out to a third party is the only end-game in town (and that the EBITDA approach is the only way to value an agency).
For many owners, selling to a third party—be it to one of the big holding companies, a large independent, private equity group, or mid-size agency across town—may very well be the correct path to monetization, retirement, or their next career challenge.
For owners who have invested 10, 20 or 30 years in building their businesses, the decision to sell is a HUGE career milestone that requires deep, existential soul-searching. Very often, it is the intangible, non-financial factors that prove most decisive, and have caused many an owner to walk away from the altar six or more months into the negotiations—for the simple reason that the proposed transaction simply “didn’t feel right.” Given what’s at stake, it is critical—for those who are contemplating an exit, as well as those who have no specific plan in mind but hope to exit in 5 to 10 years—that owners understand and give full consideration to all of their options for monetization—including selling to a third-party, selling to your leadership team via a Management Buy Out Plan (MBO), recruiting additional members of a “Successor Management Team” for a MBO, merging, forming an ESOP, or retaining control and instilling incentives for your management team to run the business.
The pros and cons of third-party deals
From strictly a financial perspective, a third-party deal may offer the biggest payday for the seller, particularly if it is a strategic transaction that can demand a high valuation. In such deals, the owner typically receives 20% to 30% up front, with the balance paid out over three to five years in the form of a performance-based earn-out tied to the seller’s legacy business and/or contribution to the income or profits of the buyer.
For owners who do not wish to exit for some time, selling to a third party offers many additional upside advantages that can enable the seller and his or her employees to further advance their careers and reap greater financial rewards than what might be possible by staying the course as an independent firm. Being free of the management and administrative responsibilities of running a business, having access to additional talent, resources, and clients of the seller, working on more prestigious accounts, and increased opportunities for cross-selling are just a few additional reasons why outside deals are attractive to sellers.
But the common perception that outside deals are more financially lucrative than an inside deal—i.e., selling to a partner, management team via a MBO—is not true in all cases, particularly for firms with AGIs (fee and retainer income) under $5 million. Internal transactions typically have longer time horizons than outside deals, often as long as five to seven years or more. During this time, owners can continue to receive distributions or dividends based upon the profitability of the business. The accumulation of these distributions, plus additional tax-favorable payout strategies, can amount to more dollars in the seller’s pocket than payments from a third-party.
The future payouts from both inside and outside deals are subject to risk based upon future performance. Since the purchase price for an external deal is largely based upon the anticipated cash flow generated by the seller’s acquired profit center, the seller must realistically assess the fundamental financial assumptions on which the deal is based. Will all of his or her clients want to transfer their business to the new agency? Will they accept the higher billing rates of the buyer? Will all key employees want to join the new firm? Will the seller be under greater pressure to meet the financial goals the buyer established in order receive the earn-out?
Then there are the existential personal issues. Can I work for someone else? Do we share the same values? How will it impact my lifestyle? Do I really want to disrupt the culture and esprit de corps of our independent agency? These are common concerns of owners.
Getting to know the buyer and his or her management team to ensure you share the same values and vision, and that there is good cultural compatibility—even before financials are exchanged—can help you assess and hopefully alleviate many such concerns. A buyer willing to provide greater autonomy to the seller, perhaps as a director of a division, vertical sector, or niche offering, or willing to allow you to retain your brand, could also make an acquisition more appealing.
Buyers aren’t crazy about owners whose sole motivation is to find a quick exit path to their retirement villas—particularly if the seller does not have a locked in senior management team in place that will help retain clients and generate new. They typically prefer sellers who view an acquisition as an opportunity to supercharge their careers by folding their businesses into the buyer’s agency, becoming part of its senior management team, and leveraging their collective talents and resources to explore and conquer new horizons together.
Selling to your management team or group of employees
Who knows your business, clients and work processes better than your own management team and employees—who, after all, have invested their own share of “sweat equity” over years or even decades to help you build your business?
For many owners, their own employees represent the most natural buyers for their agencies. The employees get to acquire an established business and enhance their personal net worths, there’s less disruption to clients, and, from a financial perspective, structured properly, the owner may be able to achieve an equal or higher payout than from an outside deal.
But how can a partner, management team, or group of employees with little or no personal funds to invest, match the offer of a mega agency? If your agency can continue to generate cash flow in the 15% to 20% range (that is, pretax net income as a percentage of AGI, after fair market salaries for officers), there are a number of financial strategies that can be employed, including but not limited to:
- Selling shares for a note, and allowing the acquiring partner(s), managers, or employees to pay for the shares from future distributions
- Redeeming the owner(s)’s shares back to the corporate treasury over a period of time while the seller maintains control until paid in-full
- Securing an SBA loan, which typically allows for a 10-year payback period
- Establishing a sinking or corporate savings fund to partially prefund and collateralize the deal
- A hybrid approach, which may consist of the succession team giving the owner a “down payment” from personal funds or a bank loan; the company offering tax-favorable payouts to the selling owner in consideration for consulting services, or intellectual property; plus deferred compensation or special retirement plan, such as a SERP
The key to an inside deal is time—to prepare your firm and management team, identify and recruit additional talent if needed, make the payouts to you more affordable to the inside buyers by spreading them out over 5 to 10 years, and perhaps to acquire a firm to add capabilities and talent to further enhance your top and bottom lines—and future payout.
More than a few owners chose the inside path simply because they wanted to see the business they built continue on after they exited—and reward those who devoted so much of their professional careers to helping them achieve their business vision.
Forming an ESOP
While not very common in the marketing services industry, the creation of an ESOP is another viable option. An ESOP is essentially a IRS-regulated plan that allows ALL employees of a business to participate in its ownership, while providing significant tax advantages. Since it can be somewhat costly to establish and administer on an ongoing basis, an ESOP probably makes most sense for agencies with 50 or more employees, and annual income of $5 million or more.
Maintaining control while instilling incentives for others to run the business
It’s your business, your “financial engine”—one that has enabled you to live your current lifestyle, enjoy the perks and freedom that are well-deserved fruits of your labor (and more than offset the many challenges and speed bumps along the way).
Why sell at all?
Why not just slow down, maintain control, continue to take distributions or dividends, participate in the professional and community activities you enjoy, and come to the office—on your terms and timetable?
With a motivated and energized management team, and well-structured incentive plan (with or without equity provisions), working as long as you like, and as much or as little as you like, is a very viable option. Some owners choose to maintain control well beyond the traditional retirement years, while others might sell 49%, and still others might retain 10% to supplement their retirement income and perhaps serve as a consultant or member of their agency’s board.
To be in the position to retain control and work less, you must reduce the dependency of the company on you. That means you need to mentor and prepare your senior managers to run the business, and/or recruit additional talent who can generate new business and create strategies for clients at a high level. That will take planning, incentives, money, and time. But by reducing the dependency on you, your company will be better positioned to be monetized in the future, whether you retain control or sell.
The choice is yours
Given that an owner’s exit plan will very likely represent the single most important business transaction in his or her career, with so much at stake, it is prudent that all owners contemplating a sale or succession carefully evaluate all of their options before committing to one strategy. And they should do so 5 to 10 years before they plan to exit or retire. A well-wrought succession plan should serve as a strategic plan or roadmap for managing your business during the critical build-up years prior to your desired exit date—with the goal of enhancing the value of your business to maximize your future payout. In a nutshell, a succession plan is all about building and monetizing business value.
The process begins with a feasibility analysis of all options, future-looking financial models illustrating various payout scenarios and strategies—and above all, some serious, realistic soul-searching. Talking to your key employees about their future hopes and desires—as well as your family and loved ones, is also part of your process, as well as assembling the right team of trusted advisors.
You built a business, and a great lifestyle. You deserve all the rewards and benefits of being a successful entrepreneur.
What is the right way to the exit for you?