Lessons from the TrenchesBuilding Private Company Value

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Sponsors:

Host:

WELCOME: Leadership ForumJanuary 14, 2014

Today’s Panelists

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Dave BosherDirector, Advisory Services, Fahrenheit Advisorsdbosher@fahrenheitfinance.com

Ben EnglishPartner, Hirschler Fleischer benglish@hf-law.com

Tripp Leonard, CFPPartner, Virginia Asset Management, LLC tripp.leonard@vamllc.com

Barry JohnsonManaging Director, Windward Advisors, LLC bjohnson@ToWindward.com

Mike GracikManaging Partner, Keiter mgracik@KSHGS.com

Introduction

• Transitions put many facets of a company under a spotlight

• Owners and managers may not be aware of some S.W.O.T.

• Lessons learned by others can help you and your company

• Interdisciplinary team approach

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Key Discussion Topics Legal considerations

Building business value

Tax and succession planning

Owner objectives and capital allocation considerations

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Key Legal Considerations

• Use legal agreements as risk management tools

• Clear and current contract provisions

• Rights in intellectual property

• Ownership interests and the securities laws

• Employment-related agreements

• Estate planning

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Plan Your Work and Work Your Plan – Fundamentals for Success• The most successful companies:

• know their core competencies

• have a keen understanding of their markets and their own positioning

• have clear mission statements and corporate objectives which are communicated throughout the organization which are S.M.A.R.T. (specific, measureable, attainable, relevant & time-bound)

• continually measure performance to goals and objectives while remaining fluid to adjust as conditions require (SMARTER – evaluate, re-evaluate)

• A Starting Point – A corporate self-assessment (Situational Analysis):

“It is a capital mistake to theorize in advance of the facts” –Sherlock Holmes-

• performing a Strengths, Weaknesses, Opportunities and Threats (SWOT) analysis, both at the corporate and business unit level

• best done with both management and Board participation

• A SWOT analysis gives rise to:• prioritized actionable plans

• Provides the basis for a formal strategic plan• Business Logic (customer, product, economic, structural)• Operating Environment (customer, competitor, economic, technological, social, political, legal, and

physical)6

Building Business Value

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Key Considerations in Building a Strategic Plan

• Establishing a functional advisory board• Engaging competent trusted advisors• Assessing growth strategies - organic and/or acquisitions• Capitalization of the business• Building organizational depth• Developing scalable and solid business information tools:• management, operational and financial reporting• establishing key performance metrics

• Development of detailed metric-driven projections and forecasts with full management participation

• Continual communication throughout the organization of performance to goals

• Leveraging the knowledge base of the entire organization and rewarding achievement 7

Building Business Value

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External Value Drivers

• Availability and access to debt and equity capital• Industry condition and trends

• Growth attributes• Stability• Cyclicality• Fragmentation• Consolidation trends• Technology• Product or service risk

• Competition• Economic environment, investor confidence • Political environment (i.e. coal industry)• Public market valuations• Company performance relative to competitors and economy• Strategic buyers’ appetites for acquisitions

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Internal Value Drivers• Solid performance record and operational consistency

• Meeting plans and projections• Consistent pattern of growth• Good internal controls and reporting structures which support accountability

• A well thought-out collaborative strategic and growth plan• Identification of new markets where you can win and lead• Creating sustained competitive advantage• New products and proprietary processes• Increased sales channel efficiency in current markets/products

• A solid management team• Leaders that can manage independently• Experienced, “A” players in key positions

• Focus on proprietary assets, products and revenue streams• patents, trademarks, brands, intellectual property, etc.

• Customer and vendor diversification• Effective management of capital to maximize ROI and preserve capital for growth• Environmental or legal risks• Effective internal governance • Efficient legal corporate structure

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• Typical Fact Pattern• Founder is sole shareholder; one child active in the business and another is interested; two not

interested• Founder owns real estate and controls all key business relationships• Management team is solid but needs new CFO

• Objectives• Create liquidity to fund retirement• Create opportunities for children interested in the business, while being fair to those who are not• Ensure ongoing viability of the company• Minimize taxes

• Financial Considerations• Issues

Does founder have realistic expectations of ability to fund retirement? How to transition control while minimizing taxes?

• Solutions Get a valuation Exempt gifts of stock Redeem founder stock with a combination of senior debt and seller note

Is company cash flow sufficient to service the debt? Seller note terms retain significant control for the founder Consulting agreement for founder Key man life insurance on CEO son

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Succession Planning - Building/Retaining Business Value

Succession Planning - Building Business Value Management Considerations

Issues Ability of the management team to operate without the founder? Will the heir apparent be up to the task? Will non-family management remain with the company?

Solutions Carefully orchestrated transition from founder to successor Training and mentoring for successor Evaluate qualifications and provide training for family members Create incentive for non-family management Strategic planning built around business and family goals

Family Considerations

Issues Is Founder ready to pass the torch? Does successor really want the job? Should family members not working in the business own stock? Is employment a birthright? How to make it fair for everyone?

Solutions Honesty and communication Founder develops a plan for life beyond the business Arm's length evaluation of family members as employees (CEO or otherwise) Bifurcate management and ownership of the business Use other assets to allocate value to children not involved in the business

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Owner Objectives - An Investor MindsetOwner Objectives: ‘Personal’ & ‘Corporate’ are Interconnected

• Owner’s unique objectives drive strategy• Be able to articulate answers—annually--- to the following:

• Desired timeframe in current role• Owner’s required value (versus desired) from the business• Desired successors of the business

• Anticipate Trouble

• Creative destruction• What keeps you up at night? Invest in it.• The “Institutional Imperative”—BRK 1989 Shareholder letter– “For example:

1. As if governed by Newton's First Law of Motion, an institution will resist any change in its current direction;

2. Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds;

3. Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and

4. The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.”

Owner Objectives - An Investor Mindset• Think Like an Investor: Capital Allocation Framework

• Owner-level thinking vs. Operator• The reinvestment decision: The “What Will They Do With the Cash” Factor

• Reinvestment opportunities offered by the operating company• Bolt-on/strategic acquisitions• Stock repurchase (less relevant in closely-held corporations)• Dividend (distribution or bonus in closely-held corporation)

• To invest/diversify• Or, to consume

• Understand constraints:• Illiquidity

• Liquidity is defined as an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value;

• With an illiquid asset, the lack of ready buyers leads to larger discrepancies between the asking price (from the seller) and the bidding price (from a buyer) than would be found in an orderly market with daily trading activity.

• Risk premium• Business valuation multiple

• Capital allocation flexibility– a competitive advantage

• Diversify your balance sheet

Berkshire Hathaway, Inc. : Holding Company Structure

Operating/Control Non-Operating

Liquid/Marketable Securities:INSURANCE

Regulated Cap Intensive

Manufacturing, Service, & Retailing Operations

And 65+ Others

Company Cost* Market

(in millions)American Express Company 13.7 $ 1,287 $ 8,715The Coca-Cola Company 8.9 1,299 14,500ConocoPhillips 2.0 1,219 1,399DIRECTV 3.8 1,057 1,154IBM 6.0 11,680 13,048Moody’s Corporation 12.7 287 1,430Munich Re 11.3 2,990 3,599Phillips 66 3.3 660 1,097POSCO 5.1 768 1,295The Procter & Gamble 1.9 336 3,563Sanofi 2.0 2,073 2,438Tesco plc 5.2 2,350 2,268U.S. Bancorp 4.2 2,401 2,493Wal-Mart Stores, Inc. 1.6 2,837 3,741Wells Fargo & Company 8.7 10,906 15,592Others 7,646 11,330

Total Common Stocks at Market $49,796 $87,662

Cash & Cash Equivalents $42,000

Fixed Maturity Securities $32,000

As per 12/31/2012

Capital Allocation StrategyInvestor Paradigm:

Owner-Based Planning

Operating/Control

Non-Operating

Qualified Investments

401Ks/IRAs/Profit Sharing

Operating Account

The Reinvestment Decision

Investable Asset Base

Commercial/Inv Real Estate Liquid/Marketable Securities:

XXX Capital Commercial Building

Appendix

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Internal Value Drivers1. A solid, motivated management team 2. A realistic growth strategy3. Effective operating systems and processes4. A solid, diversified customer base5. Proprietary products and technology6. Effective financial controls and processes7. Consistent, growing financial performance

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• Scoring On These Issues Determines Long-term Value

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Internal Value DriversA solid, motivated management team

Leaders who can take it to the next level Leaders who play well together Leaders who will help you develop a healthy corporate

culture

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Internal Value DriversA realistic growth strategy

Key components include, but are not limited to: Developing market strategy to win in current markets creating barriers to entry identification of new markets creating sustained competitive advantage Assessment of quality of business processes new products

Developed collaboratively with management team and board Assessment of organizational talent Determination of acquisition opportunities Capital requirements to execute the strategy

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Effective operating systems and processes ability to sustain the growth and scaling of the business integration of operating, ERP and financial systems systematic talent recruitment and training processes documentation of key processes and work flows

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Internal Value Drivers

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A solid, diversified customer base target markets with solid growth attributes minimal revenue concentration in a few key accounts Demonstrable high retention rates High customer satisfaction scores

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Internal Value Drivers

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Proprietary products and technology products insulated from competitive encroachment will support premium pricing product development finely tuned to target markets

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Internal Value Drivers

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Effective financial controls and processes detailed, bottoms-up financial plans and projections strong internal controls

accountability driven documentation of key processes

disciplined internal governance who approves large expenditures contract approvals pricing controls compensation adjustments

Financial reporting tailored to the business Supports tracking of actual to business strategy and tactics Effective use of dashboards and KPI reporting

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Internal Value Drivers

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Consistent, growing financial performance consistency of results leads to a premium value Intentional, unyielding focus on accountability and performance to

promises/plans effective use of capital

Working capital management Investment spending tied to strategic plan objectives

instill a culture of continual operating improvement

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Internal Value Drivers