Minority Exits

While considering the sale of your company, selling only a portion of your business may cross your mind. Many business owners have all their wealth tied up in their company, even though doing so may be considered risky. Selling a piece of your company allows you to create liquidity while still maintaining control of the remainder of your business. It also allows you to focus your talents on the division you think has the greatest potential. It’s important to remember that selling a business is not always an all-or-nothing proposition. Just ask Jack Welch.

General Electric CEO Jack Welch was well-known for divesting businesses as a way of “pruning” the company to give way to the growth of the remaining business units within GE. In his first four years as GE’s CEO, he divested over a hundred business units accounting for about 20% of GE’s assets. Welch eliminated over 100,000 jobs through layoffs, forced retirements, and divestitures. During Welch’s 20-year reign, GE’s profits grew to $15 billion from $1.5 billion, as market valuation increased to $400 billion from $14 billion. 

Publicly owned companies, which are usually under intense pressure to meet projected quarterly earnings, commonly sell non-core divisions. And so can you, even if you’re no Jack Welch. 

Selling a piece of your company allows you to create liquidity while still maintaining control of the remainder of your business. 

Why Businesses Sell Part of Their Companies

The sale of a portion of a business is called divestiture. This typically happens when a company’s management decides they no longer want to operate a business unit or asset. 

So, why do businesses sell part of their companies? Here’s why: 

• A divestiture is often a means of focusing on the core competencies of the company by spinning off non-core divisions. In other words, a business may divest divisions that aren’t part of its core operations to allow the entire company to focus on what it does best. A company’s strategic development plan may involve divesting or spinning off non-core businesses while strengthening core operations through a series of disciplined acquisitions.
• Companies sometimes make bad acquisitions and later divest those divisions to correct their mistakes. The buyer may be too large, and the new company may suffer from a lack of attention after the acquisition. Sometimes, poor management decisions lead to a need to divest non-performing business units. Selling a weak division is a straightforward management decision.
• Selling non-core divisions could also be a way to raise funds. A divestiture generates cash at the sale, with that cash being invested in more promising opportunities that can yield higher returns. Also, a company’s individual components are sometimes worth more than the company as a whole. Therefore, breaking up the company and selling its pieces can yield more than if the business were sold in its entirety.

Deciding to Sell a Portion of Your Business

As a business owner, you don’t need to sell your entire company should you decide to retire or cash out. With proper strategic planning, you can often sell just a piece of your company, allowing you to generate additional funds for your retirement or provide you with growth capital to invest back into your business.

As the owner of a mid-sized company, the decision you face may not be as straightforward as it is for the management of large companies like General Electric.

When deciding whether to sell the whole company or only a portion of it, first examine the overall value of your business and then the individual value of each division. It may be possible to sell your business in pieces to extract the most value.

You have two main options in selling a portion of your business:

1. Sell a Percentage: Selling a certain percentage of your entire company is usually structured as a percentage of your stock. This type of sale is often called a recapitalization and is commonly used by business owners looking to retire in stages. These business owners may just want to take some cash off the table. 
2. Sell a Division or Unit: Many companies are acquired for strategic purposes. A buyer may see tremendous value in one division of your company while seeing little value in your other divisions. If this happens, you may consider a spin-off of one division. 

Selling a Division Is a Strategic Decision

The cost of keeping a non-performing or non-core division could be much higher than the returns that could be generated by selling that division. This strategic decision could free up your time and energy, allowing you to focus on your core operations, potentially dramatically increasing its value as well.

A common example I encounter is a business that originally started as a single retail location and gradually evolved into a business with multiple retail outlets and significant online sales. Splitting the business into two divisions – an online division and a retail division – may make the company easier to sell and potentially maximize its value. Many buyers have a strong preference for online-based businesses and a strong aversion to retail businesses, or vice versa. Selling the divisions separately solves this problem.

Splitting your company in two may make it easier to sell, boost its value, and ultimately increase the final selling price. Value is directly related to risk. The higher the risk, the lower the value. By splitting the business into two, you potentially reduce the level of risk for the buyer. Why? Because few buyers possess the skills and knowledge necessary to be successful in multiple domains, such as in both the retail and online realms.

If your business consists of two segments but can only be sold as a whole, the buyer may view one segment of your business as excessively risky if they lack experience in that segment, and the valuation will therefore be lower. Most buyers’ skill sets are concentrated in one domain. Therefore, to use the example above, if both the online and retail divisions can be sold separately to buyers who have a strong background and experience in each domain, the risk will be lower for each buyer, and you will potentially receive a higher purchase price because of the reduced risk.

Many companies develop additional product lines as a part of their overall corporate growth strategy. In the process, many business owners create product lines they later regret pursuing. The product line may not fit in with the overall operations or may make the business owner lose focus on their core business. In that case, selling the product line can make sense.

Additionally, many buyers search for strategic acquisitions and have specific criteria regarding which businesses they’ll consider. They may be interested in just one component of your business and may not pursue your business as a whole because your other divisions don’t align with their strategy.

Popular divestitures include the decision of former Hewlett-Packard CEO Meg Whitman to spin off and merge the company’s non-core software assets with Micro Focus, a British company. This transaction was valued at about $8.8 billion, significantly less than the $11 billion it spent to acquire the division five years earlier. 

Even smaller companies can benefit from splitting their businesses into separate divisions and selling them individually. For instance, some businesses require special licensing, so breaking the business into two divisions may be prudent, as some companies may only be interested in the divisions that don’t require the licensing.

Regardless, the decision should first be considered from a strategic standpoint, so you should ask yourself if selling a division will help you accomplish your long-term objectives. Only after you’ve considered the strategic elements of the decision should you consider the tactical components, or the “how to’s,” which I’ll address next.

Consider the Operational and Legal Implications

After you’ve decided that selling only a portion of your business aligns with your long-term objectives, you’ll be confronted with the operational realities of doing so. Navigating the legal structures while managing your business is no easy task. The following explains how to handle some of those challenges. 

Operational Implications

You must first be sure your division can be segregated from an operational standpoint before considering the legal implications. Some divisions are so intertwined that it’s impossible to separate them, or doing so could prove too costly. 

Do you have a separate website, phone number, and facility for each division? Can costs be accurately allocated between divisions? Do you have employees who share duties for each division? If so, which division would they remain with? The answers to these questions should be considered as early as possible to determine how practical it is to separate the divisions from an operational standpoint. In many cases, significant work needs to be done to separate divisions on an operational basis.

Few buyers want to take the risk of creating a separate website, hiring new employees, and completing the dozens of other tasks involved in establishing a new division unless you’re selling a unit, such as a product line that can be easily integrated into another company. 

If the division is likely to be run as a stand-alone entity by the buyer, you should run it as a stand-alone business with a separate P&L for as long as possible before putting it on the market. Doing so will make the business easier to sell and will simplify the process of valuing each division separately. This will also increase the chances of the buyer being able to obtain third-party financing for the transaction. Running a division independently prior to beginning the sales process will make it notably easier to sell. Hawking an integrated division as a divestiture will make it much more difficult to sell.

Legal Implications

When selling a division, there are two main methods for structuring the deal from a legal perspective – asset sale or stock sale: 

• One Entity: If your business is one entity – such as a corporation or LLC – with two segments, your only option is to structure the sale of one of the divisions as an asset sale. In an asset sale, your entity sells the individual assets of the division to the buyer via an asset purchase agreement (APA), and the assets are listed and transferred separately in a bill of sale. The APA is sometimes called the definitive purchase agreement – the name simply indicates that the agreement is definitive or is the final agreement signed at closing.
• Separate Entities: If each division is a separate entity, the sale can be structured either as an asset sale or a stock sale. A stock purchase agreement (SPA) is used for a stock sale, and an asset purchase agreement (APA) is used for an asset sale. In a stock sale, you sell the shares of the entity that owns the division and its assets. Because the entity owns the assets, there’s no need to transfer the assets separately.

Recapitalization

You also have the option of selling a percentage of your company, usually by selling a portion of the shares of your entity. But this method of divestiture defeats the purpose of focusing on your core competency because you’ll still own all divisions post-closing. This type of sale is often called a recapitalization, or “recap,” and is commonly used by business owners contemplating retirement but who aren’t ready to completely retire. 

Recaps are most commonly funded by financial buyers, such as private equity firms that purchase a minority or majority position in your business. The catch is that they expect you to use the equity injection as growth capital in your company, not for a cruise to the Bahamas. 

Private equity firms have a limited time horizon and are counting on you to grow the firm and exit your business in three to seven years. Recaps, or minority investments, are also made by corporations, but this is less common than those made by financial buyers. Recaps are best for business owners who want to receive the support of a sophisticated investor with deep pockets willing to inject some growth capital into the business. 

The decision to sell a division should begin with your long-term goals. If you wish to focus on your core division, a recap is likely not for you. On the other hand, if you want to diversify your risk and are willing to continue operating the business, a recap may be a sensible strategy.

Determining an Asking Price for a Division

The asking price for a division is determined using the same methods to value an entire business. In essence, you’re selling a cash-flow stream. To properly value the cash-flow stream, you must first measure it. And here’s where it gets tricky. 

If the two segments are closely interwoven, it may be difficult to calculate the EBITDA for each division separately. If the businesses aren’t being run as stand-alone units, a pro forma must be prepared. However, any errors in the pro forma will be magnified by the multiplier. For example, if you overstate income by $500,000 and your business is valued at a 5.0 multiple, your business will be overvalued by $2 million ($500k x 4.0 = $2 million).

Preparing a pro forma for a division can be tricky due to the difficulty of properly allocating expenses between divisions. While revenue may be easier to allocate than expenses, the impact of any inter-division transactions on revenue must also be considered. When allocating expenses, you must also decide how to allocate fixed expenses. 

For example, if your facility costs are currently $20,000 per month for both divisions, what would a reasonable rent be for each division separately? The same idea goes for allocating other forms of corporate overhead such as salaries, insurance, professional fees, advertising, and marketing.

An alternate method is to value the business as a whole and then assign weights to each division based on the revenue that each division generates. Such a calculation would only be reasonable if the two divisions have similar margins and expenses, such as with two similar product lines.

For example, if your company generates $20 million in revenue and is valued at $10 million, and “Division A” generates $12 million in revenue, or 60% of the total, and “Division B” generates $8 million in revenue, or 40%, then Division A would be worth $8 million ($10 million x 60%). 

While assigning weights to each division may seem to be a reasonable computation, some buyers may not accept this type of calculation. Buyers tend to be wary of such estimates because assigned weights are likely to understate the amount of fixed expenses and therefore overstate income or margins. Because of these inaccuracies, profitability may differ significantly between divisions.

Ideally, the divisions should be valued based on the profit each division generates. Unfortunately, doing so involves numerous assumptions that are prone to error. A back-of-the-envelope method for obtaining a ballpark valuation for each division isn’t difficult, but such a ballpark estimate is unlikely to suffice for most buyers. A ballpark estimate should only be used for internal planning purposes – and for valuing ballparks.

If a buyer is looking to obtain a division of your company for strategic purposes, different valuation methods should be considered. 

In such cases, you should prepare a pro forma P&L based on your division being integrated into the buyer’s company. It’s likely that certain functions for the division, such as HR, legal, and accounting, will be centralized by the buyer, which will reduce expenses and increase income for the business and therefore, increase its value. 

While a reduction in expenses is considered a safe bet, buyers are less likely to pay for revenue synergies than synergies resulting from reduced costs. Even in the case of operational synergies such as reduced costs, you must aggressively negotiate to receive value for these. 

This is compounded by the fact that buyers rarely provide you with their financial models or pro formas, so the best you can do is prepare an estimate and negotiate to receive as high a percentage of the synergies as possible. 

Selling a Division is a Strategic Decision

In some cases, it only makes sense to sell your business as a whole. In other cases, the wisest course of action is to sell your divisions separately. Your decision depends on a number of factors that a professional can help you evaluate. You should first examine the overall value of your business and the value of each division separately. Once you’ve done this, you should clarify your long-term objectives and determine if selling a division or selling your company as a whole is the best way to meet your goals.

Regardless, the decision to sell a division or segment of your business is strategic and should be based on your long-term objectives. Consider the following questions when deciding whether to sell your company as a whole or in parts:

• Would I be happier if I simplified operations and focused solely on my core business?
• Have I spread myself too thin? If so, would selling a division help sharpen my focus?
• Knowing what I know now, would I start both divisions again?
• Which division produces the most profit for me?
• Which segment of the business is most suited to my skills and strengths?
• How hard would it be to sell each segment separately?
• Is it practical to sell each segment separately?
• What’s the potential value of each division?
• What’s my number one bottleneck now? 
• Do I need growth capital to significantly grow my business? If so, would selling one of the divisions free up enough capital and energy to allow me to focus on my core competence?
• If I sold one of my divisions, could I reinvest the money in the remaining division and significantly boost revenue and income?

Once you consider the answers to these questions, as well as the operational and legal implications, you can determine the wisest course of action. Regardless, you should retain a professional to examine your business and advise you on the best way to proceed. Your plan of action depends on several factors that an expert can help you evaluate, including how much stake you want to have in the future of the company. Also, having your business valued as a whole and in pieces can help you decide what will yield the highest price. Either way, a professional will be able to assist you with selling your business however you want, so don’t be afraid to seek professional advice.

Remember that selling a portion of your business doesn’t mean giving up something – it only means letting go of a “part” to let the “whole” thrive. After all, the cost of keeping a non-performing or non-core division could be much higher than the returns.

Conclusion

As discussed, a $20 million all-cash offer isn’t the same as a $20 million offer with $1 million down and a $19 million earnout. When receiving an offer, you should evaluate the various financial and legal components to determine how favorable it is compared with others on the table.

You should first evaluate the form of consideration. How is the purchase price being paid? The purchase price can be paid as follows:

• Cash: This can include cash the buyer has on hand, third-party financing, or the assumption of long-term debt.
• Seller Financing: The terms of the seller note and the creditworthiness of the buyer should be considered.
• Stock: The financial health of the acquirer and liquidity of the stock should both be carefully considered.
• Earnouts: Earnouts are a complex matter and should be carefully considered before you commit to one.
• Employment or Consulting Agreements: These are normally guaranteed payments but are taxed at ordinary income tax rates to you, as opposed to long-term capital gains tax rates.
• Holdback/Escrow: Most transactions include a holdback, although the terms of the holdback should be analyzed to ensure they are reasonable.
• Royalties and Licensing Fees: Licensing fees are less commonly used and are designed to compensate you for new product launches.

Next, you should evaluate the legal structure of the transactions. Most small and mid-sized transactions will be structured as asset sales. If that’s the case, the allocation of the purchase price is critical and will have a tremendous impact on your tax implications. The allocation of the purchase price should be carefully analyzed by your accountant to determine if it’s reasonable and to evaluate the extent to which taxes can be mitigated.