Chapter Exit Strategy C H A P T E R

Chapter Objectives Describe the techniques that can help spot financial trouble. Understand how to reorganize a troubled business. Appreciate how a company can avoid bankruptcy by selling assets. Describe the process of selling a business. Calculate the value of a sport business.

Red Flags Key factors associated with business failures include economic weakness, industry downturns, poor location, too much debt, too little capital, and countless other reasons. A lender’s request for early repayment of a loan could be a sign that the company is in trouble. (continued)

Red Flags (continued) Following are reasons a bank might call a loan or not renew a line of credit: Loan covenants have been repeatedly violated. The bank is losing money on the relationship. New bank managers favor a different loan mix or institute new policies. The bank does not understand or is uncomfortable with the industry segment. The bank’s credit exposure in the industry segment is too great. A loan guarantor’s financial condition has deteriorated. The bank has lost faith in the business’ management team. (continued)

Red Flags (continued) If a bank calls a loan, the company can do the following: –Negotiate a short-term extension to try to resolve any problems or secure new funding. –Approach another bank (if business is strong financially). –Ask the bank what the problem was and investigate if it can be fixed. –Use assets to help secure needed funds. –Approach a commercial finance company that specializes in “unbankable” loans.

Informal Reorganization This allows a business to recover and reestablish itself after facing a temporary financial crisis Voluntary plans in which all parties try to come to an agreement are often called workouts. Reorganization process comprises extensions and composition: –Extensions are extensions of the time allowed for repaying a debt. –Composition is the process of asking to repay a lower amount.

Informal Liquidation Assignment: The term used for the informal liquidation process. Liquidating assets such as stocks or other liquid assets is a way a company can pay back debt.

Removal of Business Assets Selling assets can reduce business cost or size or raise cash. Primary reasons a company downsizes include reducing income and changing focus. Here are some ways to remove assets: –Take out profits as dividends. –Business owner increases own salary. –Owners can compensate themselves for independent projects in the same way an independent contractor is paid. –Pay bonuses. –Owner can loan himself money from the business. –Owner can sell or lease property to the business.

Selling a Business Reasons for selling a business include the following: –Wishing to retire –Wanting to make a profit –Wanting to change careers –Wanting to get out while they can –Finding the level of competition unacceptable First step in selling any business is to gather together all relevant financial information. If purchasing a business, the key component is knowing exactly what will be purchased. (continued)

Selling a Business (continued) There are four options for selling a business: 1.Taxable sale of company stock 2.Tax-free sale of company stock 3.Taxable sale of company assets 4.Tax-free sale of company assets (continued)

Selling a Business (continued) Asset vs. Equity Purchase –The person or other company interested in buying the business would prefer to buy assets rather than stock for various reasons. To reduce the purchasing company’s liability –There are significant tax considerations for the seller and the purchaser of assets as opposed to stock. –Benefit of selling assets involves the “step-down” basis for depreciable assets. Step-down provision is particularly important in the professional sport industry in that players’ contracts are considered depreciable assets. (continued)

Selling a Business (continued) Calculating Business Value –Valuation is the process of determining a business’ value. –Sport valuations must incorporate numerous additional factors when determining value: Total risks, the competitive environment, the business’ assets, when the valuation was conducted, and the business’ ownership structure (continued)

Selling a Business (continued) Typical valuation may include the following steps: –An estimate of future benefits of the business based on some combination of earnings, cash flow, revenues, assets, and potential future value of the business –An estimate of the capital required between the purchase price and expected future investments –A risk-adjusted estimated cost of capital or discount rate to be used in the valuation –An analysis of the timing, taxes, personalities, and other nonfinancial factors that may influence a valuation (continued)

Selling a Business (continued) These documents are needed for valuation: –Complete financial statements (balance sheet, income statement, statement of cash flow) for at least three years Supplemental financial statement schedules such as compensation schedules for employees and officers, ownership distributions, dividend payment schedules, and key-person life insurance policies may also be important when assembling an economic picture of the business –Federal and state income tax returns for the same period –Operating information Company history, marketing materials, copyrights, trademarks, patents, organizational charts, customer and supplier databases, contractual obligations, and so on (continued)

Selling a Business (continued) These documents are needed for valuation: –Planning information regarding current budgets and forecasts Particularly of capital requirements such as future capital expenditures, deferred maintenance, and future working capital requirements –Business formation documents Corporate or partnership agreements, employee contracts such as noncompete agreements, and employee stock option purchase (ESOP) agreements (continued)

Selling a Business (continued) Techniques to Calculate a Business’ Value –Asset-Based Valuation Methods The business’ value is determined based on the value of tangible and intangible assets, net of liabilities. Net worth is computed based on factoring in assets that appear on the balance sheet along with assets that might not be recorded. Technique is most relevant for valuing an established sport business or in cases in which the valuation is being done in response to the sale of an ownership stake that exceeds 50%. Asset Accumulation Approach –This approach requires identification and summation of the current economic values of all assets, tangible and intangible, that are controlled by the sport business as of the date of the valuation. (continued)

Selling a Business (continued) Techniques to Calculate a Business’ Value –Asset-Based Valuation Methods Excess Earnings Method –Value of net tangible assets is estimated on the basis of the return that these assets can generate. –Market-Based Approach This approach gives the value of the sport business based on a multiple of operating results, such as profits or revenues. Value of the business based on market-derived multiples reflects informed decisions negotiated between parties in transactions. Market multiples are derived based on multiples of earnings and revenues. –Obtained either from analysis of publicly traded companies similar to the business or from data on actual transactions involving acquired or merging public and private companies (continued)

Selling a Business (continued) Techniques to Calculate a Business’ Value –Income-Based Approaches Value is estimated based on the present value of all earnings and cash flow that the company provides to the owners during the time it is owned. Discounted Net Cash Flow Approach –Estimates the present value of future economic income that is expected to result from the operations of the business –Is used because conceptually it represents all income that an investor can hypothetically take out of the business –Value is then computed as the sum of the present value of the annual net cash flows over the forecast period plus the present value of the terminal value. –The concept of discounting recognizes that money received in the future is worth less than it would be today.

Additional Considerations When Selling Do not let employees know too early that you might be selling; this can affect employee morale. Do not let competitors know too early about an impending sale; they might try to steal customers or hinder the sales process. Do not accept a purchase agreement calling for the seller to receive cash and a note; the note could be worthless if the new owner runs into financial hardships. (continued)

Additional Considerations When Selling (continued) Do not accept a significant bonus based on future financial success; you will remain tied to the business and its potential success or failure. Do not get so involved in the sales process that the business suffers and becomes even more difficult to sell. Do not specifically exclude certain assets from the final sale, such as cash, past-due accounts receivable, deposits, refunds, and other valuable assets such as business records.

Questions for Class Discussion 1.What is the best technique for determining the value of a business? 2.If you were facing financial hardship what signs do you think you would be able to see? 3.Is it better to buy an entire business or just its assets? (continued)

Questions for Class Discussion (continued) 4.Is there a difference in determining the value of a large business such as a professional sports team versus a smaller business such as a health club? 5.Do you think it would be a good idea for a team owner to sell a team to the players? 6.If you were selling a sport business, what strategies would you use to try to find potential buyers?