Succession Planning and Management Blog

Small and medium businesses could become more profitable if they invest more time in training leaders, making their staff happy and by giving employees more leadership opportunities, according to a new Government-sponsored report.

The new Leadership, Culture and Management Practices of High-Performing Workplaces report, which is set to be launched today at the Future Jobs Forum, surveyed over 5,600 employees from 78 companies, mostly SMEs. The report found businesses that adhere to “high performance workplace” characteristics are generally more profitable than businesses that do not.

University of New South Wales senior lecturer Christina Boedker, who helped research and compile the report, says there is now a culture of organisations that are high performing – and SMEs can learn a lot from them.

“If you do this stuff right, it pays off, and in monetary terms as well. We’ve collected actual financial data, and we’ve seen that these high performing companies generally have a correlation with higher profitability.”

The study found that high performing companies spend 29.3% more time and effort managing their people than leaders, 25.7% more have clear values, 22.9% have a higher occurrence of giving employees the opportunity to lead work assignments, while 21.1% encourage employee development. 17.9% have clear vision and goals for the future.

High performing workplaces are also categorised as having higher levels of innovation with services and products, operational processes, managerial structures and strategies, and marketing methods, while they also generate 28.1% more new ideas.

They have lower levels of employee turnover (23.3%), with 22.7% having higher levels of job satisfaction.

But bigger financial were identified. The report found a considerable difference between the profits of low performing companies and high performing companies.

“The profit margin difference between high performing workplaces and low performing workplaces is large and reaches $8.8 million dollar per organisation, or $40,051 per full-time employee.”

“In other words, a low performing workplace could potentially increase its profit margin by up to $8.8 million on average if it were to successfully migrate into the higher performing workplace category.”

Boedker says there is also a correlation between profitability and happiness. In low performing workplaces, one in four employees had symptoms of depression, while in higher performing workplaces, that ratio was just one in seven.

“This correlation brings out the importance of considering people’s emotional stability at work. We are emotional beings and the report shows we get affected by all sorts of different things, and then bring that into work.”

“The higher performing companies have cultures where they care about the employees, and they have that emotional support in place, and it comes out in the financial data as well.”

Boedker says the report teaches SMEs to focus on leadership, and training leaders to empathise with staff, in order to promote higher performing workers.

Leadership skills has one of the strongest correlations with productivity, so focusing on those capabilities and management is a key characteristics of the higher performing companies.”

Boedker also points to higher levels of responsiveness to changes in stakeholder and customer networks, higher levels of employee participation in decision-making processes, higher level of behaviour and skills flexibility in employees, and effective use of quality IT systems as aspects of higher performing businesses.

“We pay attention to the business plan and finances and so on, and that is important, but leadership capability and emotional stability are just as crucial.”

GF Data’s Second Quarter 2011 Report reveals that the size premium – the reward in valuation for larger businesses over smaller similar ones – is now the defining dynamic in middle market business exit and succession planning ( or M&A) . The second quarter data shows unprecedented differentials in valuations based on deal size being applied to small versus large deals in the middle market, indicating the resurgence of an even more severely bifurcated market that is less accommodating to smaller transactions.

Despite the overall average valuation for the first half of 2011 being on par with 2010’s average of 5.8x trailing twelve months adjusted EBITDA, the valuations for deals in the $10 million to $25 million total enterprise value (TEV) range are averaging 5.2x while valuations in the $100 million to $250 million range reached a record-high average of 7.5x – over a full turn higher than 2010’s 6.2x.

In terms of deal volume, the 160 private equity firms currently contributing to GF Data reported 28 completed transactions in the second quarter of 2011, just down from the 32 reported in Q1, but significantly lower than the 63 deals completed in the fourth quarter of 2010. Deal volume remains sluggish largely due to the downdraft created by the scarcity of new product coming into the M&A market in the final four months of 2010, a record-breaking quarter for middle market deal-activity fueled by anticipated (yet never enacted) tax law changes.

“We began this year by predicting that the story of middle market deal activity in 2011 would be a resurgent premium for greater deal size joining the premium for better deal quality as a driver of value,” said Andrew Greenberg, CEO and Co-Founder, GF Data. “As predicted, size premium is now driving the market. The primary dynamic in this quarter’s data is not the tail off in deal activity, which actually was remarkably similar to Q2 2010, but rather that valuations are rising in the $50 million to $250 million total enterprise value range with little if any increase on smaller transactions.”

“The size premium also extends to, and to some extent is caused by, disparities in debt availability to larger and smaller businesses,” said B. Graeme Frazier, IV, Principal and Co-Founder of GF Data. “While this is not apparent in the overall data, when you look at Total Debt/EBITDA multiples for deals in the $10 million to $25 million TEV range they are on par with 2010 levels in the high two’s, yet for larger deals, Total Debt/EBITDA went from an average of 2.8x in 2010 to 3.9x in the first half of 2011. Essentially what we are seeing is a market that is far less accommodating to smaller deals, a trend that has been evident in our data since 2009, but was most exaggerated in the previous quarter.”

Additional Data Highlights:

• In 2Q, the overall valuation average dipped slightly to 5.7x. GFDR believes overall valuations are in fact not declining—that this is more a function of the mix of deals reported—and that the first and second quarters of 2011 are best viewed jointly.

• In 2009 and 2010, strong financial performers were valued more highly than other acquired businesses in both the $10-50 million and $50-250 million value ranges. However, in the first half of 2011, valuations across the $50-250 million range have surged from the mid-sixes to the low-to-mid sevens, while averages on the smaller deals remain in the mid-fives, demonstrating that the quality premium has been overtaken by a size premium.

• Yet another sign of a market less accommodating for smaller deals is the incidence of earn-outs and seller financing. In the first half of 2011, in the $10-25 million TEV category, 79 percent of transactions utilized an earn-out or seller financing. This is a big jump from the normal average of 40-50 percent for all transactions every year since 2003 (2008 was an exception, with the figure rising to 61 percent).

GFDR collects, analyzes and reports on private equity-sponsored M&A transactions in the $10 million to $250 million value range. GFDR’s quarterly reports contain high-level valuation and leverage data. The firm also provides detailed valuation data in specific industry categories through its web site. Individuals and companies interested in more information can contact GF Data Resources by visiting their website www.gfdataresources.com.

Many business owners veiw a business exit or succession plan as a short-term plan to sell the business for the best possible price and whilst this may be possible ( and in fact many business brokers simply work on this model ) it is often not the best means of achieving the best return for the owners upon exit.

Like everything, if you are prepared to put in the extra work and effort and truly prepare the business for an exit strategy you will maximise the value and return to shareholders – with many of our clients this is a matter of identifying areas of risk, improving financial performance and then seeking to identify and attract a strategic buyer – sometimes a listed company, sometimes an offshore entity – this combination alone will maximise the value upon exit and generally far outperform a simple sale that most business owners would normally pursue.

We have had some considerable success with various clients by following an acquisition and expansion strategy as part of an overall exit plan – many small businesses, whilst successful and performing well and valuable in their own right, are simply not large enough and do not contain enough synergies for larger companies to acquire on any strategic valuation. Therefore, one part of our strategy may well be to acquire complementary businesses ( for example part of our vertical supply chain ) merge together businesses that supply a similar product or service the same client base with different product, or even operate very similarly in different geographic areas. This will increase the size, capacity and efficiency of both businesses and we managed effectively should ensure both sell for a higher figure than they would have done individually.

Obviously, this increases the timeframe and is a strong argument for a strategic succession plan to be in place long before the owner actually intends to exit the return on equity and increase in overall strategic valuation should be more than enough to compensate.

Many of the private equity firms and merchant banks that fund these kinds of transactions have minimum thresholds and simply to get your business to a size where these thresholds apply will improve firstly your chances of a successful sale or exit and secondly the valuation at the time.

A US based case study that models this is Advantage Sales and Marketing (ASM), a food brokerage that started as a $10M organization. After using this process and rolling up with 16 other similar organizations over four years, ASM sold a 75% interest to Allied Capital in a transaction valued at 5.5x EBITDA ($268m). Less two years later, ASM sold again for $1.05B or 9x EBITDA, resulting in a 7x ROI for Allied and the ASM member-owners. ASM sold again in December 2010 for $1.89B.

The latest survey covers performance during the quarter to end July 2011 and expectations forward for the rest of this financial year, and is the result of responses from over 1800 business owners – approx 1,400 small businesses and about 400 medium businesses ( more than 20 employees ) . Key findings were:

Business confidence fell further during the last quarter, with confidence now at the third lowest level recorded in the 18 year history of the index.

In line with the drop in confidence, there were also falls in all key performance indicators, wiht strong falls in particular recorded in sales and profitability. The latest fall left the profitability indicator at its lowest level in the history of the index. For the year ahead SMEs were expecting further falls on all indicators.

A lack of work or sales remained the primary concern of SMEs this quarter with a large increase in concern levels. This was followed by the economic climate and cash flow.

Support for the Federal government’s policies fell a further seven percentage points in the last quarter. The key reasons SMEs gave for feeling that the Federal government policies worked against them included the carbon tax and a view that the policies were impacting consumer confidence and spending. Net support has not seen lower levels since the Keating Government.

Confidence was highest in the health and community services sector but lowest in the retail trade sector. Regional businesses were more negative than metropolitan ones about the current state of the Australian economy as well as more negative on where the economy will be in one years time.

In terms of planned activities – 22% of business owners said they wanted to personally work less in the business, 18% said they were looking to seek professional assistance to grow and 17% said they would sell or close the business during this financial year. Interestingly 38% planned to increase their digital presence and 26% said they wanted to introduce to increase their social media activities.

Picture this: within five to 10 years there will be thousands of small business owners each year who are forced to close their enterprise upon retirement. After a lifetime of hard work they will walk away with nothing, because there are not enough buyers at a fair price. Many employees will lose their jobs, and country towns in particular could lose some small businesses that provide important services.

I doubt if enough politicians grasp the significance of a generation of baby boomer operators of small businesses leaving the workforce this decade and next. Or the effect that years of poor superannuation returns will have on their exit strategies. If they did, there would be more considered long-term thought and even policy action to help plan for and manage this incredible business transition.

With business owners needing a good three to five years to plan their exit, this is the time to act.

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Business and insolvency experts tell me that more small business owners are already struggling to find buyers for their enterprise upon retirement. And that’s when the trend of baby boomers leaving the workforce is still in its infancy and when the Australian economy has solid fundamentals. Imagine what happens as the trend of baby boomer retirements peaks around 2020.

About one in four business operators in Australia were aged 55 or over in 2007, Australian Bureau of Statistic (ABS) data shows. In raw figures that’s just over half a million enterprises. My hunch is the proportion of business operators aged 55 or over will rise when figures are recalculated based on latest census data: poor superannuation returns will have forced more people to delay retirement, while others who were unable to sell their enterprise for a good price will have kept working.

Care is needed with these ABS statistics, which are based on a survey and prone to sampling error. It is likely that a chunk of the total 1.92 million business operators provide services, such as consulting, where they are the business, and closing rather than selling the venture is expected. And rising life expectancies could see more operators work longer than previous generations.

Even if you halve the 296,000 business operators aged 60 or above, there are thousands of small enterprises that must to be sold each year in the next five to 10 years. This glut of business sales could come at precisely the wrong time if US and European economies have another five years of economic pain (a “lost decade”, like Japan) and the global economic recovery is tepid. Heaven help us if the non-mining part of the Australian economy weakens further, just as more business operators need to sell.

Smart owners of enterprises already have one foot out the door. A recent KPMG family business survey found 59 per cent of respondents would consider selling their enterprise if approached by a genuine buyer. But just over a third of respondents said their business was “exit” or “succession” ready. The majority of respondents had annual turnover above $1 million, meaning even more sophisticated private enterprises have plenty of work ahead to make themselves ready for sale.

What chance do smaller enterprises have to engage in serious exit planning or succession strategies, especially if they are struggling to keep the business profitable, let alone plan for an exit that may be some years away?

The danger is ageing business operators abruptly decide to sell when they have had enough; which is the worst possible time and strategy to get a good price. Or that weaker trading conditions mean less investment in the business now, and less ability to get a good price later.

A more important question is where will buyers come from? Think about the traditional exit mechanisms: a trade sale to another company; selling to private equity; an initial public offering on the sharemarket; the succession of younger family members to run the business; and a partial exit by hiring external management to run the company while the business operator retains majority ownership.

I see fewer Generation X and Y people wanting to run the family business over the next decade. Most businesses needing to be sold will be too small to raise capital and list on the sharemarket, or attract private equity. Trade sales will always be the key exit path, but with a glut of businesses wanting to sold, valuation multiples could fall.

One business broker last week told me that valuation multiples of about six times earnings before interest and tax (EBIT) prior to the GFC, for a quality small business worth more than $5 million, are now around 3.5 to four times, and a good chance of heading below three times – a huge destruction in value.

I suspect that more business operators will have to make partial exits by hiring external management, possibly selling them some equity, and slowly leaving the business over time.

The federal government can play a big role in managing this transition. It should provide more support for business operators who are approaching or past retirement age, and who want to hire external managers to run their business. Here are four ideas for federal and state goverments:
•Launch awareness campaigns to emphasise the importance of engaging in exit/succession planning several years before the event
•Consider a tax rebate for business owners over 60 who engage corporate advisors, accountants, lawyers, and wealth-management experts on succession/exit-planning issues. Maybe half the fee could be rebated (instead of the usual tax deduction now), provided there were strict guidelines, so sharks and shonks could not rort the subsidy
•Consider a tax rebate for business owners over 60 who form an advisory board to provide advice on exit/succession planning and other strategic matters. Perhaps half the director fees could be rebated through the tax system (instead of the tax deduction now), to encourage ageing business owners to form boards and tap external advice. Again, strict guidelines would be needed to stop rorts
•Consider launching a federal government fund to finance part of management buyouts or ‘buy-ins’ for ventures worth $5-$30 million, where the owner is past retirement age. This would make it easier for an employee to buy out an owner who retires, or encourage external managers to join the firm and buy into it. I can’t see the banks doing enough in this space, meaning governments might have a role to provide debt capital for aspiring business owners. That’s got to be better than watching a business close and dozens of employees lose their jobs because eager buyers cannot access finance

I’m not sure what the answer is, but I do know that more debate is needed about a defining small business trend for years to come.

Most of all, we need considered thought about how to retain some commercial knowledge of a generation of retiring business operators. I would love to see formal programs where accredited retired business owners are paid a modest fee – yes, paid by the government – to mentor emerging Gen Y and X entrepreneurs or join their advisory boards, or given tax incentives to invest in emerging enterprises (under strict conditions). We could swell the number of “angel” investors overnight and build a deeper pool of patient capital for micro enterprises, which would come from experienced business operators and investors who bring much more than money.

We also need more thought about the opportunity this generational transition will present to younger people who can take the reins of many smaller enterprises and reinvigorate them. I’m convinced that within a decade, many more young people will need to create their job rather than apply for it, as big companies automate more services or outsource them overseas.

With some rare foresight, politicians could find stronger mechanisms to link thousands of business operators who need to sell, with thousands of young people who need a job, are eager to start a venture, run an existing one, or create value by reconfiguring resources through industry ‘rollups’, which could go to waste if business operators are forced to close viable enterprises.

This trend is simply too big a threat, and an opportunity, to pay lip service to, or to think that the problem is years away. It is emerging now.