by Scott Benfield and Jane Baynard

As we close in on the end of the second year of a new millennium, wholesale distributors are facing new and rigorous challenges. Continued restructuring of the industry and an increase in alternate channels that often bypass the wholesaler will continue to siphon sales from certain product lines and vertical markets.

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The distribution industry is large, diverse and highly fragmented, consisting of some large companies and many small firms. These dynamics have provided ideal ingredients for impressive implosion within the industry for the past 20 years. For example, the number of wholesalers dropped from 364,000 firms counted by the Census Bureau in 1987 to approximately 250,000 companies in the late 1990s due to mergers, acquisitions and business failures.

Given these enormous challenges and daunting industry trends, some owners are perplexed with the issue of how to get their capital out of the business efficiently. Finding ways to remove capital from a company is getting more difficult. Private company owners whose assets are primarily represented by non-marketable securities begin to feel a heightened sense of urgency to identify a way to transfer equity to cash since they are now keenly aware that the government does not want their private securities when they die. Passing stock to heirs is limited in its applicability due to onerous (upwards of 55 percent) gift tax rates. Stock-freezing techniques, which permit the stockholder to transfer future asset appreciation to heirs, have all but become a fading memory.

There is, however, a way to get capital efficiently out of the company, namely, sell the company to outsiders. Unfortunately, although distributors are consolidating at a record pace, premiums paid for distribution companies have eroded nearly 30 percent in recent history according to MergerStat Review. Additionally, fewer than 30 percent of business transactions succeed, often because of lack of planning. Finally, post-sale cultural clashes jaded many potential suitors. Many transactions have “earn-out” clauses, which tie the “goodwill” premium to the owner/seller’s ability to merge with a new culture.

Another issue facing distributors desiring to divest of their business is that, chances are, the seller founded the company on a shoestring and has essentially a zero basis from a tax perspective. Therefore, the entire transaction is subject to capital gains tax, leaving an owner with only 70 to 75 cents on the dollar.

The upshot of all this is that to successfully pull three generation’s worth of hard-earned equity out of the wholesale business, potential sellers need to be better prepared and cognizant of eroding prices, tax implications, cultural fit with the buyers and a host of other issues regarding a successful sale of their business.

These are real issues that literally tens of thousands of wholesale distributors think about but don't know where to turn for answers. Many owners aren’t sure what questions to ask. As a result, we’ve developed this series of articles to assist distributors in executing an effective divestiture strategy, which maximizes the value of their business in the current market.

Motive vs. motivation
One of the first issues to conquer involves what motivates your desire to sell the company. Simply stated, you need to have a valid reason for selling. Buyers will want to know why you're selling. The more valid your reason, the more serious the buyer will be and the more likely the price of the business will not suffer.

A number of objectives may prompt an owner or management group to sell a company. Among the most common reasons: a desire for personal liquidity; the need for expansion capital; increasing anxiety caused by personal liability and unreasonable risks; age, health and successor issues; and sheer boredom. Each can be a valid reason motivating the sale. Let’s take a look at each.

Liquidity: Divestiture can provide substantial liquidity for owners or shareholders if they are seeking funds to launch a new venture or simply to diversify their personal investment portfolios. In closely held private companies, almost all of an owner's personal net worth is often tied up in the business. The prospect of a sale offers an opportunity to convert the private equity holdings into cash. This presents individuals and families with the opportunity to diversify their investments, reallocate their primary assets and support a cash-intensive lifestyle.

Growth capital: Companies encounter a recurring need for growth capital. Whether the business growth metric is insatiable or stagnant, its need for capital is nearly always constant. Although the higher the revenue level, the higher the demand for capital, often just sustaining a competitive advantage consumes an ever-increasing amount of money. Many companies often exceed their financial capabilities and commercial credit lines, requiring them to sell out, which can offer the expansion capital required not only to thrive but even to survive. Additionally, the capital appetite for distribution is moving beyond inventory, bricks and mortar to include IT systems and more educated managers to run an increasingly complex business.

Personal liability: The most common kind of owner liability is a personal guarantee of company debt instruments. Other forms of personal liability include state and federal tax obligations, such as employee withholding taxes, product liability and personal damages. Personal pledges such as these mean that the owner is legally obligated to use his private assets to repay any obligation the company can't meet. In many circumstances, such personal guarantees originated in the early, risky days of the business and were never removed.

Retirement: Even though it’s better to sell when the market is just right for your industry to get the optimum price for your business, personal timing is often more important than the market timing. People are ready to retire based on personal considerations more than market considerations. Which leads to issues of . . .

Succession planning: Many large, older, family-owned businesses face a sweeping leadership change within the next five years, according to a recent Arthur Andersen/MassMutual American Family Business Survey, compiled with the help of the Family Enterprise Center at Kennesaw State University. More than 42 percent of family-owned businesses will change hands, and more than a quarter of CEOs will retire within five years, according to the survey of more than 3,000 businesses with average annual sales of $9 million and about 47 years in operation. More than half expect the CEO to retire within 10 years. As senior management contemplates reducing the time spent on the business or about retiring altogether, succession planning takes an ever more central role. By selling the business, the company may benefit not only by gaining greater management depth, but also by utilizing more sophisticated operating systems and accessing better financing than the current management team could on their own.

Unchallenged (big business boredom): Successful distribution enterprises are started by individuals with an outstanding skill set who are motivated by a need for freedom and want to own their own business. These companies have the early ability to find and satisfy prospective customers and literally jumpstart the growth of a business. However, once businesses get successful, they typically face predictable growth plateaus, which present owners with new and traumatic problems. Owners discover that they require different skill sets to manage a new and tougher group of competitors, grapple with the complexities of size, plus every expansion requires new capital investment. 

As if that’s not enough, owners often feel that they are no longer doing what they enjoy the most. Planning, administration, delegation and complex business decision-making are not the hallmark traits of the family CEO. Owners often lament the fact that they are overwhelmed with administrative duties, and their closest working companions are the Internal Revenue Service, banks or other lenders, the Occupational Safety and Health Administration and even the Environmental Protection Agency. Work becomes a chore; getting large doesn’t afford the freedom of the smaller firm, and the expected salary increase is not directly correlated with size.  The extra salary seems to go out to higher ticket managers to handle the big, nasty wholesale organization. Suddenly, owners realize that the business can be sold today, generating enough cash to live on comfortably without the constant headaches. The old adage, “it’s better to cash out than burn out” is often a reality!

Whatever your motivation for selling the business, it’s important to articulate it clearly and logically to prospective buyers. Selling your company can be a rewarding financial experience, or a process with considerable frustrations. The information and tools we will supply in this series will help you understand the selling process, how to value your wholesale distribution company and assist you in assembling the team of professionals to get the transaction done correctly. If you’d like to see where you and your company are on the “readiness continuum,” a copy of our “Are You Ready To Sell?” questionnaire is yours for the asking. Just e-mail us at the address below. In the next article, we’ll delve into what you can expect in the selling process and how to manage it.

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