Harvesting the entrepreneurial venture
J. William Petty
Introduction
Harvesting is the final phase in the entrepreneurial value creation process, which includes building, growing, and harvesting. Harvesting is the process entrepreneurs and investors use to exit a business and liquidate their investment in a firm. While all three phases are important pieces of the entrepreneurial process, many entrepreneurs who fail to execute a successful harvest do not realize the full benefits of their years of labor.
Harvesting is the means for capturing or unlocking value, reducing risk, and creating exit options. It is about more than money, as it also involves personal and non financial considerations. As a consequence, even upon realizing an acceptable monetary value for the firm, an entrepreneur who is not prepared for the life style transition that accompanies the harvest may come away disappointed with the overall outcome. Thus, crafting a harvest strategy is as essential to the entrepreneur’s personal success as it is to his or her financial success. The message to the entrepreneur is this: the time to develop an effective harvest strategy is now, not later.
As a firm moves toward the harvest, two questions regarding value are of primary importance. First, are the current owners/managers creating value? You can harvest only what you have created. Value is created when a firm’s return on invested capital is greater than the investors’ opportunity cost of funds, which re lates both to the firm’s operating profit margins and its efficient use of total capital invested. Second, could a new set of owners create more value than the current owners? If so, then the firm would have greater value in the hands of new owners. Growing a venture to the point of diminishing returns and then selling it to others who can carry it to the next level is a proven way to create value. How this incremental value will be shared between the old and the new owners depends largely on who wants the deal the most or who has the most leverage.
We will now look at the harvest options avail able to the entrepreneur. We then offer recommendations for avoiding problem areas in the harvest process.
Harvesting Options: How Do We Capture the Value Created?
There are three commonly used ways to harvest an investment: (1) selling the firm, (2) releasing the firm’s free cash flows to its owners, or (3) offering stock to the public through an initial public offering (IPO).
Option 1: Selling the firm. Unquestionably, selling the firm is far and away the most common approach for entrepreneurs and investors to exe cute the harvest. The issues arising from the sale of a firm – like any harvest strategy – involve questions of how to value the firm as well as how to structure the deal. When selling a firm, the entrepreneur, for all practical purposes, has one of three choices: strategic sales, financial sales, and employee sales. The strategic buyer is interested in synergies, the financial buyer is interested in existing business cash flows, and the employee buyer is interested in preserving employment.
Strategic sale
From the seller’s perspective, the key point in a strategic acquisition is that the value strategic buyers place on the business depends on the synergies that the buyers think they can create.
Since the value of the business to the buyers derives from both its stand alone characteristics and its synergies, strategic buyers often pay a higher price than purely financial buyers, who value the business only as a stand alone entity.
Financial sale
Financial buyers, unlike strategic buyers, look primarily to a firm’s stand alone cash generating potential as the source of value. Often, the source of value the financial buyer hopes to tap relates to stimulating future sales growth, reducing costs, or both. This fact has an important implication for the owner of the firm being purchased. The buyer often will make changes in the firm’s operations that translate into higher pressures on the firm’s personnel and may result in decisions that the original owner was unwilling or unable to make, which frequently levies a high cost on the firm’s employees.
Employee stock ownership plans
ESOPs are a way for a firm to be sold either in part or in total to its employees. A wide variety of companies have used these plans for many reasons. As a method of selling an entrepreneurial company, though, an ESOP appears to be the last resort, behind strategic and financial sales.
Option 2: Releasing the firm’s free cash flows. The second harvesting strategy involves the orderly withdrawal of the owner’s investment. The withdrawal process might be immediate if the owner simply sells off the assets of the firm and ceases business operations. However, for a value creating firm – one that earns attractive rates of return for its investors – such would not make economic sense. The mere fact that a firm is earning rates of return that exceed the investors’ opportunity cost of funds indicates that the company is worth more as a going concern than a dead one. Thus, we would not want to rationalize the company; instead, we could simply not continue to grow the business, and in so doing increase the ‘‘free cash flows’’ that can be returned to the investors.
In a firm’s early years, all its cash flow is usually devoted to growing the firm. As a consequence, the firm’s free cash flow during this period is zero or even negative, requiring its owners to seek outside cash to finance its growth. As the firm matures and the opportunity to grow the business declines, sizable free cash flows frequently become available to its owners. Rather than reinvesting all the cash flows in the company, the owners can begin to withdraw the cash, thus harvesting their investment. If they do so, only the amount of cash that is necessary to maintain current markets is retained and re invested; thus, there would be little if any effort to grow the present markets or expand into new markets.
Harvesting by withdrawing the firm’s cash outflow has two primary advantages: the owners can retain control of the firm while they harvest their investment, and they do not have to seek out a buyer or incur the expenses entailed in consummating a sale. There are disadvantages, however. Reducing reinvestment when the firm faces valuable growth opportunities results in lost value creation; it could leave the firm unable to sustain its competitive advantage while the owners are harvesting the venture. If so, the end result may be an unintended reduction in harvestable value, compared with the potential value of the firm as a long term going concern. There may also be tax disadvantages to an orderly liquidation compared with other harvest methods. Finally, for the entrepreneur who is simply tired of day to day operations, siphoning off the free cash flows over time may require too much patience. Unless other people in the firm are qualified to manage it, this strategy may be doomed to failure.
Option 3: The IPO. Many entrepreneurs look to the prospect of an IPO as the ‘‘holy grail’’ of their career. However, in reality, an IPO is used primarily as a way to raise additional equity capital to finance company growth, and only secondarily as a way to harvest the owner’s in vestment.
The IPO process may be one of the most exhilarating – but frustrating and exhausting – experiences of an entrepreneur’s life. Managers frequently discover that they do not like being exposed to the variability of public capital markets and to the prying questions of public market investors.
From the entrepreneur’s perspective, it is necessary to consider the shift in power that occurs during the IPO process. When the chain of events begins, the company’s management is in 142 harvesting the entrepreneurial venture control. They can dictate whether or not to go public and who the investment banker will be. After the prospectus has been prepared and the road show is under way, however, the firm’s management, including the entrepreneur, is no longer the primary decision maker. The investment banker is now in control. Finally, the marketplace, in concert with the investment banker, begins to take over, and ultimately it is the market that dictates the final outcome. This process can be disconcerting to the entrepreneur if all does not go as expected.
In addition to the issue of who controls the events and decisions in the IPO process, it is important that the entrepreneur understand the investment banker’s motivations in the process. Who is the investor banker’s primary customer here? Clearly, the issuing firm is rewarding the underwriter for its services through the fees paid and participation in the deal. But the investment banker is also selling the securities to its customers, who typically will be involved in future deals. As a result, the investment banker may have a tendency to favor the buyers of the firm’s stock more than the firm that is going public. The entrepreneur just needs to be aware of the potential conflict.
Developing an Effective Harvest Strategy
Based on in depth interviews with entrepreneurs, investors, and investment bankers located across the US who have been part of one or more company exits, we offer the following suggestions to avoid problems in exiting the venture (for the complete study, see Petty, Martin, and Kensinger, 1999).
When designing the terms of the harvest, cash is king. Other things being equal, cash is generally preferred over stock and other forms of remuneration.
Anticipate the harvest. Investors are always concerned about how to exit, and entrepreneurs need to have a similar mindset. Peter Hermann, general partner at Heritage Partners, a private equity investment group, notes: ‘‘People generally stumble into the exit and don’t plan for it.’’ However, for Hermann, ‘‘The exit strategy begins when the money goes in.’’ Jack Kearney, formally at Rauscher, Pierce, and Refsnes, indicates that an exit strategy should be anticipated in advance, unless ‘‘the entrepreneur expects to die in the CEO chair. The worst of all worlds is to realize, for health or other reasons, that you have to sell the company right now’’ (Petty, Martin, and Kensinger, 1999: 55).
Having an exit plan in place is also important, because the window of opportunity can open and close quickly. The opportunity to exit is triggered by the arrival of a willing and able buyer, not just an interested seller. From the perspective of an IPO, hot markets may offer very at tractive opportunities.
Having bought businesses does not prepare you for selling your company. Entrepreneurs who have been involved in the acquisition of other firms are still ill prepared for the strains and stresses associated with selling their own businesses. A buyer can be quite unemotional and detached, while a seller is likely to be much more concerned about non financial considerations.
Get good advice. Entrepreneurs learn to operate their businesses through experience gained in repeated day to day activities. However, they may engage in a harvest transaction only once in a lifetime. Thus, they have a real need for good advice, both from experienced professionals and from entrepreneurs who have personally been through a harvest. Jack Furst at Hicks, Muse, Tate, and Furst believes that advisors can give entrepreneurs a reality check. He con tends that, without independent advice, entrepreneurs frequently fall prey to thinking they want to sell unconditionally, when in fact they really want to sell only if an unrealistically high price is offered.
It is also wise for an entrepreneur to talk to other entrepreneurs who have sold a firm or taken it public. Professional advice is vital, but entrepreneurs stress the importance of talking with someone who has exited a company.
Most of all, understand what you want. For an entrepreneur, exiting a business that has been an integral part of life for a long time can be a very emotional experience. When an entrepreneur invests a substantial part of his or her working life in growing a business, a real sense of loss may accompany the harvest. Thus, entrepreneurs should think very carefully about their harvesting the entrepreneurial venture 143 motives for exiting and what they plan to do after the exit. Entrepreneurs who exit their investment frequently have great expectations about what life is going to be like with a lot of liquidity, something many of them have never known. The exit does provide the long sought liquidity, but some entrepreneurs find managing money – in contrast to operating their own company – less rewarding than they had expected.
Entrepreneurs may also become disillusioned when they come to understand more fully how their sense of personal identity was intertwined with their business. Peter Hermann states: ‘‘Seller’s remorse is definitely a major issue for a number of entrepreneurs. Search your soul and make a list of what you want to achieve with the exit.’’
Summary
Harvesting is the means entrepreneurs and investors use to exit a business and, ideally, unlock the value of their investment in the firm. It is more than merely selling and leaving a business. It involves capturing value (cash flows), reducing risk, and creating future options.
There are three basic ways to exit an investment in a privately owned company: (1) selling the firm, (2) releasing the firm’s cash flows to its owners, or (3) offering stock either to the public markets or to private investors.
The following advice is offered to any entrepreneur wanting to harvest a business investment:
- Cash is king.
- Anticipate the harvest.
- Selling a firm is not the same as buying.
- Entrepreneurs have a real need for good advice, both from experienced professionals and from those who have personally been through an exit.
- Be careful what you wish for – you may get it. So understand what is important before harvesting your personal and financial in vestment in your company.
Bibliography
Petty, J. W., Martin, J., and Kensinger, J. (1999). Har vesting Investments in Private Companies. Newark, NJ: Financial Executive Research Foundation.