What's Your Exit Strategy?

IN MANY RESPECTS, the restaurant industry is no different from most other industries. It faces the same cyclical ups and downs, changing consumer preferences and similar economic factors that other service and manufacturing industries do.

A key difference between foodservice and other industries is the composition of its underlying ownership. Unlike other industries, individual ownerentrepreneurs comprise the majority of ownership in the restaurant industry. While our industry has its share of publicly traded companies, the main engine is fueled by entrepreneurial activity.

Most restaurant entrepreneurs ultimately are seeking the profitable sale/transfer of their business or some other related exit strategy. In many cases, the entrepreneur views this liquidity event as the final one-time windfall that will provide for retirement and long-term financial stability.

The dynamics of entrepreneurial ownership create unique implications for a restaurateur's successful exit strategy. Two factors are critically important: The entrepreneurial life cycle, also called the e-curve, and the application of a disciplined portfolio strategy. Understanding the relationship between and the importance of coordinating these two concepts is the key to a successful exit strategy.

The e-curve can be segmented into the following stages: inception/ startup, expansion/growth, maturation and transition/exit.

During the inception/startup phase, the restaurateur conceptualizes a restaurant or buys into a chain concept, identifies a core market, raises capital and begins marketing. Risks are high, but hopes are higher.

At the second stage, expansion/ growth, the restaurateur proves his or her concept a success and scales it into multiple units as additional markets are secured and samestore sales experience strong growth. The restaurateur's passion and enthusiasm generally peak during this period.

During the maturation phase, the concept has reached a level of critical mass and developed some operational inertia. Profitability and size peak, but overall growth rates tend to slow as the concept matures. During this stage the successful restaurateur often will reap the rewards of success and spend less time on day-to-day business demands. Asset diversification becomes a consideration; the owner may start to think about selling the business and consider retiring or reinvesting into another business. At the same time, the successful restaurateur often spends more time in the pursuit of another passion. At this time, called the lifestyle inflection point, it is common for the business to experience a period of slower or static growth.

In the final transition/exit stage, the restaurateur has spent a good portion of her professional life building a successful concept and realizes a bulk of her wealth is tied up in the business. Accordingly, as a matter of intelligent wealth management, she concludes that it's time to diversify assets by harvesting the success of the business.

Disciplined Portfolio Strategy
As with any transaction, a disciplined portfolio strategy is a critical to preserving the company's ultimate value when it comes time for a sale. Such a strategy requires establishing objective performance measurements and constantly assessing market conditions to determine the best timing for a transaction. Professional investors (e.g., private equity firms, institutional traders, pension funds, etc.) have long understood the importance of applying a disciplined approach to harvest their profits. Their sole focus, just as it is for the restaurateur, is the profitability and ultimate capital gain from their investments. However, the professional investor and the entrepreneur differ in three key ways in how they achieve this goal. The following differences can have profound implications on their respective approach to exit strategies:

Definitive profit/timing objectives—Professional investors typically set a specific time frame during which they intend to hold an investment and/or a specific level of desired profitability. When their goals are met, they are disciplined in executing an exit strategy. By contrast, the entrepreneur-owner usually does not preestablish specific timing or capital gain objectives. It's easy to understand why. Each entrepreneur will follow the life cycle according to a different schedule, so it can be difficult to predict the future.

Passive versus active involvement—Professional investors have a passive role in the day-to-day operations of their investments, enabling them to focus exclusively on the overall strategic performance attributes of the investment. Entrepreneur-owners, on the other hand, are consumed by day-to-day responsibilities and active management that often fulfill a much-needed sense of accomplishment, not to mention providing a current living income. As a result, they rarely focus, as professional investors do, on the ultimate value of their investment or on a strategy for harvesting that value.

Emotional attachment—The entrepreneur-owner has a passionate attachment to the business. It is a living, breathing entity that he has created and, in a very real sense, it's "his baby." Dealing with the separation and ultimate sale of the business, therefore, can often be difficult because the business is more than just a livelihood末it's a large part of the owner's identity. The professional investor, on the other hand, has no emotional involvement with the business; in addition, it usually is much simpler to liquidate a position than to sell an entire business built over a lifetime.

Coordination: The Key
How do the e-curve and a disciplined portfolio strategy influence a satisfactory exit strategy? The answer is coordination.

Given future growth prospects for the business and the entrepreneur's active and personal involvement in managing the company, objective performance measurements are not the sole determinant of the optimum time to sell a business. For instance, if the business is still in the first three stages of its e-cycle, it's not time to sell. Growth has not been maximized; thus, the market may be favorable, but the life cycle stage is not. Executing a transaction when both conditions are favorable requires the entrepreneur to coordinate her position on the ecurve with optimum objective performance measurements, including current market conditions.

For instance, as the entrepreneur moves into the maturation stage, the timing on the e-curve becomes more advantageous. A shrewd owner will begin to apply and incorporate key portfolio strategies (e.g., market timing, profit objectives, company performance, postsale reinvestment options, etc.) to be ready to act when conditions are favorable.

The benefits of coordinating these two factors are clear. Acknowledging in advance that he will inevitably reach Stage 3, 4, and the lifestyle inflection point (see box on previous page) will better equip the entrepreneur to recognize these stages as they are occurring and will help him act swiftly at exactly the right time. This preparation will better enable the restaurateur to sell from position of strength while in the beginning of Stage 3 and before value declines, as it so often does in late Stage 3 and 4.

Frequently, an entrepreneur does not actively plan for transition and fails to establish objective measurements as part of an overall portfolio strategy. This often results in holding onto the business too long, thereby missing the optimum window of opportunity and ultimately diminishing the value.

Often, for example, owners with businesses well into the maturation phase have lost the enthusiasm and passion they once had for the business but fail to pursue an exit strategy. Frequently in such situations, the company's profitability has declined due to passive management, concept trends, commodity price increases or other factors outside the owner's control. The entrepreneur delays preparing for an exit because he believes that waiting will increase the value of his business.

Some owners who have experienced tremendous recent profitability believe things will continue to improve unabated. As a result, they assume waiting will yield higher profits and value. Enthusiasm is dangerously high. Typically, they ignore the risk associated with the execution of the business, competition and general market conditions.

Finally, owners in the third or last business stages sometimes recognize that it is time to sell, but have not prepared for the emotional separation from the business. Frequently, these owners have not identified a suitable activity/ investment to replace the day-to-day function of running the business. The business simply is still too much of a part of the owner's identity and therefore key decisions are set aside.

In all three situations, the owner's delay often results in a poorly timed exit strategy. So, what should an entrepreneur do if faced with one of these issues?

Timing Is Everything
A common mistake during the maturation phase is an attempt to recoup lost profits or gain new profits at the expense of time or missing a favorable market. While everyone would like to sell when their company is at peak performance, this not the only key consideration. Trying to maximize the value by delaying a sale could backfire and actually cost the owner money, even if performance improves. How? Like everything else, markets for restaurant concepts fluctuate over time.

To see how this works, consider the example in the box above. In this example, the restaurant's sales and EBITDA revenues improved by 10 percent, total proceeds declined nearly $1.0 million. The reason? In this example, market multiples contracted, and the purchase price declined from 6.5X EBITDA to 5.5X EBITDA. Conversely, the market could go in the other direction. That is why it is critical to assess market conditions and coordinate your timing objectives with optimum market conditions. Objectivity is the key. Be aware of the historical and current range of market multiples. If the historical range is 4.0-6.0X, don't fall into the trap of thinking "the market is hot and I might get 7.0X if I wait." In conclusion, coordinating the ecurve with a disciplined portfolio strategy will assist in maximizing the exit value of a business. This requires (1) developing an understanding of the e-curve dynamics, (2) assessing one's position on that curve, (3) adopting a disciplined portfolio strategy and starting to plan for the inevitability of the late maturity and transition/exit stages and (4) focusing on coordinating the location on the e-curve with an objective view of market conditions and the company's performance.

For owners currently approaching the maturation stage, market conditions-seem favorable right now. Merger and acquisition-activity and business valuations are showing signs of a strong rebound with valuations for smaller businesses at their highest levels since 2000. Similarly, overall M&A activity is the U.S. is at it highest level since 2000. Private equity firms are sitting on billions of dollars and many are actively seeking attractive deals in the restaurant sector. Considering the abundant signs of an economic rebound, now may be the best time in years to contemplate how the e-curve and a disciplined portfolio strategy apply to your present situation.

How Market Multiples Affect Purchase Price
  Year 1 Year 2
Revenues $10,000,000 $11,000,000
EBITDA (1) 1,000,000 1,100,000
% Growth NA 10%
Market Transaction Multiple 6.5x 5.5x
Purchase Price $6,500,000 $6,050,000
% Change in Price NA -7%
Return on Sale Proceeds(2) $520,000 NA
TOTAL PROCEEDS $7,020,000 $6,050,000
Difference as a % 14%  

(1)EBITDA: Earnings before interest, taxes, depreciation and amortization
(2) Assumes owner will earn 8% return on sale proceeds that is foregone by delaying the sale to Year 2.

For more advice on exit strategies, contact the Cypress Group (www.cypressgroup.biz [4]), which provides a full range of investment banking and strategic advisory services to the franchise and multiunit restaurant industry.