Chapter 9
Strategic Exits

“Jeff, this division has been losing money for years and offers no strategic advantage to the parent company. We need you to visit and let us know how to shut it down as efficiently as possible,” said the private equity chairman. I drove deep into central Pennsylvania to a rundown, tired, and well‐past‐its‐prime metal widget factory. They didn't even produce their own widgets, they were a low‐tier job shop for mostly automotive customers. The division had been starved for cash since the bankruptcy of its parent company 10 years prior. What happened since was pure financial mismanagement, and this scrappy little division was now having to beg customers to buy the input materials because they could not get basic requisitions funded from headquarters far away in Kansas. This was driving customers away, and sole‐sourced parts were now getting shopped around. Blood was in the water.

Long story short, I liked the business and I thought it would be a perfect acquisition for a strategic buyer but a risky acquisition for a financial buyer. My liquidation plan would net about $10 million for creditors, which would be a fair recovery from this level of mismanagement and neglect. But all the jobs would get wiped out, the county would lose its biggest employer, the tax base would take a hit, and hundreds of families would struggle to recover in an already depressed region. If I did everything right, got lucky on valuations, and tidied up all loose ends, it would still be a soulless victory. The town, county, region would be permanently harmed, and if I drove through 20 years later, I'd feel I had played a part in the decline.

Like a house buyer, I thought the company had “nice bones”; the employees knew their stuff, and even though they had grown soft over the years, they sincerely wanted another chance at success. The equipment was falling apart, but they had a good range of capacity in an adequate building. There were a dozen things wrong with the business, but still they had good customers and a decent backlog of orders. In my opinion, if you have a backlog, you probably have a business. I liked the customer list, I liked the industry, and I saw low fruit everywhere in operations. In the hands of a good operator, this business would flourish, these folks would all keep their jobs, and I'd go out of my way to drive through this small town 20 years from now.

I called my client and persuaded him to let me try to sell the business. Remember the salvation process from Chapter 5? That's what we did starting at a distressed sale. Our downside scenario was shut down and liquidation for about $10 million, which would go straight to the bank as the parent company, was deep in debt. In 60 days we had three strong offers with deposits.

• Offer 1: $15 million cash as going concern. Will strip out the equipment and move to another factory an hour away. Buyer owned by family with very strong balance sheet.
• Offer 2: $28 million with about half cash and the other half paid over time or performance based. Keep factory in town with promises to grow it. Private equity buyer.
• Offer 3: $30 million all cash, close in 60 days, keep the business local. Boom, done, finished.

Buyer 3 was the home‐town favorite. They had an all‐star management team of four owners, all life‐long industry experts who had outgrown their current facility. Our factory was the perfect upgrade for them, and they would manage this business like it deserved to be managed.

Each bidder was willing to pay what is essentially goodwill, more than the market value of the assets. What they were paying for was going‐concern value, the value of the money that flows through the assets. Even though that cash stream was negative, buyers saw value. The business was losing 4% per month, so about $3.2 million on $80 million in annual sales. That means if you put $100 into the company today, you'd get back 96 cents, over and over and over. No one in their right mind would pay for this business; it was like a banana on the shelf, past its prime and turning slightly more brown with each passing day.

So how did we sell the business for such a premium? We focused on key attributes and applied the pressure of a quick sale.

Key Attributes

• Customer base. Any customer who put up with buying input materials, late shipments, and lack of support as these customers had, is obviously sticky. If they hadn't left yet, why would they now? Aside from being sticky, many were blue‐chip customers on blue‐chip product platforms. Although you might otherwise spend 20 years trying to get a part on (for example) a Ford platform, this beaten‐down little company had five parts on Ford's bestselling vehicle. This immediately makes the acquirer a critical vendor with the opportunity to grow the business from there. Even a profit‐breakeven product gives you several years of contribution margin, a vendor number, a relationship, and the opportunity to bid on future business. Multiply that by a few other blue‐chip customers and you can see the value we were trying to sell.
• Customer concentration. The largest customer represented 30% of company revenue, which is a concern. If they pull out, you're in big trouble. But combined with the similar‐sized acquiring company, that concentration drops to 15% with all the benefits of a new blue‐chip customer. The same was true of industry concentration, because the high bidder was similarly overconcentrated in the agricultural equipment market, so, again, the acquisition brought immediate value in diversifying customer and industry concentration risk.
• Contribution margin. Sure this orphaned division was unprofitable, but it still had an industry standard gross profit margin. When redundancies were squeezed out, much of that gross profit margin dropped straight to the bottom line allowing for significant economies of scale. The combined companies didn't need two receptionists, two CFOs, or two vice presidents of sales or maybe even duplicative engineering or quality or production.
• Customer tools. Again, we already had all the tooling needed to service this business. The engineering, sales effort, and tooling were all sunk costs. Using the Ford business as an example, not only were we already in, all the costs associated with getting in had been spent.
• Backlog. We had six months of sales on the books, committed with customer purchase orders. Managed properly, this was money in the bank for a new owner. Many of these parts had three or more years left in their product life cycle, which, again, gave the acquiring company a bright future.
• Industry knowledge. The high bidder was an expert in the agricultural market, not the auto industry, but with this acquisition they would inherit engineering and sales teams whose average auto market experience was over 15 years.
• Years in business. When you go to market with a brand or company that is 50 years old, it signifies financial strength and stability. Even if you recently picked it up in a distressed sale.

We ran a going‐concern auction process for the business. Twenty‐two potential buyers were contacted resulting in the three premium offers mentioned above. We made it clear that this was a classic divestiture and the seller was a sophisticated corporate seller. There would be a quick and fair process without the games or the emotions you might get with an entrepreneur seller. We prepared the marketing materials, represented the company fairly but optimistically, being very clear about both the rough past and the bright future. Figure 9.1 shows historical financial statements along with our pro forma projections.

Only the high bidding party put in the time and effort to really understand the costing and profitability buried in our order book. They reverse engineered parts, rebuilt and rebid bills of materials, blind quoted parts, and rescheduled equipment to find hidden profits and were willing to pay for them. This intensive due diligence and deep expertise allowed them to be the high bidder at a bargain price.

Today the factory is thriving under new ownership. They've retained existing customers, brought in new business, exceeded projections, and added jobs to the community, preserving the tax base and property values of this isolated little town.

Distressed Buyers

As that story illustrates, the buyers who show up when a business is tanking are usually a mix of industry insiders and specialist private investors. The industry folks will be a mix of cunning bargain shoppers and tire kickers, whereas anyone naïve enough to overpay will be scared off by the company's instability. In general, strategic buyers will pay more than the private investors, because there is true strategic value in the acquisitions. Successful financial buyers of distressed businesses use speed, certainty, and professionalism to win deals at lower prices than their strategic buying counterparts.

Sellers of distressed businesses are usually either large corporations who want to divest themselves of an unprofitable division or bank workout departments who are forcing the sale of a privately owned business. Both sellers are business professionals who know that value is declining by the day and they want a clean, quick exit. We recently sold a distressed plastic injection molding business and received three acceptable offers:

1. The first offer was from a well‐heeled family‐owned business that looked like an ideal strategic buyer but was located about 800 miles away. They wanted a three‐month due diligence process and another three months to close. They seemed capable of financing the transaction, but it was going to have a significant impact on the family's wealth. The process was being run by the founder's kid who was CFO and seemed determined to showcase his brilliance through the process. The business would likely relocate and wipe out the local jobs. Their bid was for 100% of the debt owed.
2. The second offer was from another family business with much deeper pockets and five recent and similar acquisitions in the plastic molding business. These were veterans in every aspect of the business and would be an ideal future owner. They wanted six weeks for due diligence and another two weeks to close. It was obvious that they were going to be both fair and excruciating through due diligence. It was uncertain if they would keep the business in its current location or consolidate it to another factory out of state. The bid was for 80% of the debt owed.
3. The third bidder was a wealthy industrialist who built his fortune buying highly distressed businesses and holding them for the long term. Appraisals were in place, and I'd already performed liquidation analysis for the owner and bank. The industrialist's bid was net forced liquidation value on the assets, which is about 50% of the total debt owed, but also the full amount of the senior secured debt. The buyer required three days of due diligence, another seven days to close, minimal reps or warrantees. That offer would get the bank paid in full without the uncertainty of an auction, preserve the jobs, keep a tenant in the entrepreneur's building, and keep the area's largest employer in business.

If you're the bank and all you care about is getting your money back, then option 3 gets you there very quickly and with minimal risk. The bank also knows there is an unemotional, professional, experienced, and serious buyer behind the offer, which is very appealing to bank officers and attorneys. If you're the owner, the bank is making it very clear what you should do, and the business is losing money by the day. Therefore, option 3 looks pretty good to you as well. In American insolvency, only creditors have a voice. Workers and communities are mute unless they are owed past due wages or taxes. Were they to have a voice, the certainty and track record of option 3 would likely make it their top choice. Customers would also vote for speed and certainty. Vendors would be split wanting payments for past due invoices but also wanting a business they can continue with. Option 2 offers a fair recovery but with a little less speed and certainty, Whereas option 1 offered neither. Bidder #2 ultimately won.

The universe of effective distressed buyers is small. Few investors have the requisite turnaround experience and legal knowledge to take on these train wrecks. Fewer can attract investment capital for these free‐wheeling ventures, almost no one can move at the required speed, and even fewer yet have the stomach for an as‐is, where‐is purchase of a deeply insolvent business. Although most distressed purchases are asset sales, the gutsiest buyers will offer to buy all the stock of a company, no reps or warranties, sight unseen, that day, for $1, and then hope they can sort out whatever mess lies beneath.

Like selling anything, the key to selling a distressed business is to identify the likely buyers and then create an auction environment where they are bidding against each other. This is tougher in insolvency, but your limited time becomes your greatest point of leverage. We can run an extensive sales process with only two weeks between teaser, process letter, factory tours, and final binding offers. The tight deadline gets rid of tire kickers and grabs the attention of serious buyers – and serious buyers are very competitive once you have their attention. With a few distressed buyers circling the remains, I can often get a strategic buyer interested in high bidding to knock out a future competitor. “You know, Shirley, it sure would be a shame to see those distressed industrial buyers become a new competitor of yours when you can pick up all the soft assets and the gross margin contribution for still‐well‐below market value.”

Peaceful Liquidation

Sometimes you can't save or sell the business, and there are still ways for the business owner to get out gracefully. I know a gentleman who owned a languishing business. The owner was about 70 years old and his partner had died several years earlier. The business was losing money. Foreign competitors took advantage of exchange rates to undercut his prices, and he saw no relief in sight. His positive equity funded these losses but that, too, was running thin. In the end, he chose to shut down the business. Employees got a fair severance and vendors were all paid in full. He liquidated the assets, paid the bank off, and went home to focus on his golf game and grandchildren. The employees and community lost out, but not every business is saveable.

Friendly Foreclosure

But what happens when the business lacks the equity to pay off its bills and can't find a buyer? We covered that a little bit in Chapter 5 with the recycling company. Let me paint a scenario: your business is losing money, there is no buyer interested, and the bank is underwater on your loan. Perhaps you have a chain of small print shops or record stores; your customers are mostly walk‐ins and offer no strategic value to a buyer; you have no backlog, engineering, or tooling; and no one cares about your industry knowledge in a dying industry. You still want to fight, but you're down to your last nickel. And the bank – they are done. They'll take the write‐off, cut ties with you, and move on. You've got one move left: pursue full‐on crazy denial of reality or embrace a friendly foreclosure.

In a friendly foreclosure you allow the bank to take possession of the company's assets and, in exchange, they give you some relief. This is often the best prescription for everyone involved. We know that the bank holds all the cards. You can bleed away your last few dollars paying for lawyers to slow the bank's unrelenting march toward your assets – or you can deliver yourself for penance and get on with it. You agree to act responsibly, and they agree not to rip your limbs off. Seriously, that's about the gist of it. Everyone agrees that there will be a swift, prescriptive, and just cleansing of the debt with cooperation from all parties. It leaves more money in the business for creditors and less for attorneys and advisors.

I handled several friendly foreclosures in the aftermath of the 2008–2009 global recession, two of which were lumberyards. In the case of the first one, the third‐generation business owner had simply failed to run the operation well but had been kept afloat through the housing bubble. The bank was aggressive; they wanted a full liquidation and didn't mind the owner suffering in the process. My focus was on the big assets, which included about 20 acres of lumberyard, hardware store, truss facility, and commercial cabinet shop. Every so often, the entrepreneur would mention the small rented kitchen showroom an hour away, but I largely ignored it. There was no asset value there to work with and the (poorly prepared) financial statements showed losses everywhere. I contacted all the likely strategic buyers, but this was at the bottom of the housing collapse and no one seemed interested.

We managed the going‐out‐of‐business sale and scheduled the auction. The owner was going to come up short, and the bank was not yet willing to let him off the hook. During that time, I realized just how passionate the owner was about this distant custom‐kitchen business. That was his true love, and he was really good at it. The lumberyard was just something he inherited from his family. With support of the bank, the entrepreneur strategically retreated to his custom kitchen business and paid off the remaining debt from there. Five years later, the bank was fully paid off, and the owner has a debt‐free profitable business that he loves.

Another set of entrepreneurs tripled the size of their lumberyard, truss, and pallet business right at the crest of the housing boom. The huge new second location had delays and budget overruns, opening to dead silence about two months after the Lehman collapse in 2008. The bank was deeply underwater and the owners had no idea what to do next. We negotiated a friendly foreclosure, sold off the truss facility to a foreign buyer, managed a going‐out‐of‐business sale for the big new store, and listed the building with a local commercial realtor. The bank wanted every penny possible, so we also negotiated a purchase agreement and operating lease on the original small store with the wealthy owner of another lumberyard. He would fund and operate that store for up to 60 days with the option to purchase it. After 30 days he pulled out, unwilling to go forward with the purchase. My clients moved back in and pretty much sat around waiting for the bank to take the store and send them home. That store was their passion, and for years they had serviced a small but loyal group of local builders and do‐it‐yourselfers. With support from the bank, we found a way for these guys to keep the original location and support a small mortgage with a big B‐note mortgage behind it. Eight years later, they are still in business and settled up with the bank several years ago.

Other friendly foreclosures have given entrepreneurs a release from personal guarantees and a fresh start. We've bought a couple of businesses in which the talented but failed founder kept a sales‐ or engineering‐focused executive role, commensurate pay, and healthy stock options in a restarted business with a cleaned‐up balance sheet and a disciplined cost structure. It's a dignified and profitable fallback for the right entrepreneurs.

Government Collections

While a debtor is cleaning up debts with the banks, it's easy to lose site of everyone who is collecting. The bank will quickly pounce on you when results slip, but the federal government moves much more slowly, and it's easy to not see them gaining momentum. If you have an SBA‐backed loan or owe taxes, it's the same friendly folks over at the U.S. Treasury that you'll have to deal with. Their mandate is to collect “the people's money” from you and return it to the Treasury.

The restructuring of IRS, SBA, and other federal debts is done through the offer in compromise, which is a structured administrative process of dealing with insolvent government debts. Like bankruptcy, it suspends collection actions and gives you time and cover to solve these issues. You will lay yourself bare and follow a formula. The federal government will be sizing you up by thoroughly, examining all your assets, and performing an audit of reasonable recovery potential. That's the baseline collection budget they feel you are worth. It's the sum value of all your assets sold off at auction plus a large portion of your future income for the next six years. If they believe they can just liquidate you to collect, why should the U.S. taxpayer accept one penny less? That's what you're up against. An IRS defense specialist, usually an Enrolled Agent, will help you build a case and get through it with the least amount of pain.

The government does want to collect what you owe, but they don't want to be unfair and they don't want to force you into poverty, so they have developed standards with the help of the Bureau of Labor Statistics and the Consumer Expenditure Survey. This means the U.S. government has determined what minimum amount of money you and your family need to meet your basic living expenses (as defined by them, not you). It's complicated, but here's a quick summary to give you an idea:

So a family of four can support itself on less than $55,000 annually. You might notice what's missing:

• Education or college savings
• A second or third car

  IRS Monthly Allowable Expenses (2017)	One Person	Two Persons	Three Persons	Four Persons
  Food	345	612	737	845
  Housekeeping Supplies	32	65	66	65
  Apparel and Services	83	138	193	293
  Personal Products and Service	36	63	73	77
  Miscellaneous	143	254	309	370
  Housing and Utilities	1,436	1,686	1,777	1,981
  OOP Health Care (<65 y/o)	49	98	147	196
  Owning One Car	485	485	485	485
  Operating One Car	250	250	250	250
  Monthly Totals	2,859	3,651	4,037	4,562
  Annualized Totals	34,308	43,812	48,444	54,744

• Vacations
• Yacht club
• Yacht
• Kids' sports programs
• Diapers, day care
• Holiday expenses
• Retirement savings

How's that for a debt stack? You get to subsist at government standards and they collect everything else. Don't like them apples? Shall I have the U.S. Marshal show you a worse option? These are the rules of the game. The good news is that this is as tight as you can be squeezed, and only for up to six years, after which there is a jubilee and you are released from your tax obligations, assuming you were not criminal in your actions, had good representation, and were compliant throughout. Either way, we are playing tackle here folks, and if you're willing to go into debt with government funds, you need to know the price of getting out.

When your back is up against the wall and the business is absolutely not going to survive with current ownership, there are solutions. They require as much speed and complexity as any other topic we've covered in this book but in the last weeks of a business, the potential value can still swing wildly, delivering the business owner any potential outcome between a great future and what will feel like federal debt slavery.