Exit Planning for IT Service Firms

According to McKinsey & Company, an IT company must “grow fast or die slow.” Their research speaks to the fact that only 28% of IT companies manage to sustain growth and many IT business owners fail to prepare their exit plans until their businesses are in trouble–and then it’s too late.

Preparedness begins with asking these critical questions:

• What is my vision for my business?
• What is the probability of my IT products performing well in the market?
• Do I have a Plan B and, if so, what is it?

If, for instance, you start with an app, then you have successfully developed the minimum viable product and you know how it will roll out. What if it encounters problems during the launch (server issues, application crashes, etc.)? Or what if a competing version launches within a short span of your app’s launch? Surprisingly, most entrepreneurs do not have a backup plan to address these issues. Business owners of IT service firms must have a strategy for how they will enter and how they will potentially exit from that application, that system, or that market.

This is especially true in the case of young IT companies, they fail to make it through the initial trial phase to transition to a growth company. Similarly, a number of IT companies in the growth phase encounter issues: they either go out of business or are acquired by larger firms. Moreover, because of their short market history and limited or lack of financial records, it is difficult to value them. Many of these companies are funded by private capital, sometimes the owner’s savings, venture capital, and private equity. These factors make valuation tough, as standard techniques commonly used to appraise cash flows, growth, and discount rates cannot be used or, if used, give unrealistic results.

In contrast, mature IT companies, because of their experience in operation and knowledge of market conditions, do not present as many problems in a valuation, since they are able to provide most of the required inputs for a valuation from longstanding, historic data, especially beneficial for valuation analysts. Their established patterns of investments and financing lead to stable risks and returns, which in turn lead to buyers being more confident about the company. And rightfully so. Before they pump capital into a new venture, they want to ensure it’s a good investment.

This is where having an exit strategy is beneficial. An exit strategy helps business owners focus on the future and keeps them on track to achieve the growth targets and exit goals.

What Is Business Exit Planning?

Business exit planning is a structured, detailed plan that defines the transition of ownership of a business to another company or to investors. The plan enables the business owner(s) to decide when they want to exit their business, how they will exit (choosing the most appropriate exit strategy), and what proceeds they will need to execute the plan.

Ideally, exit planning process begins at least four to five years before the business owner executes the transition. An exit planning advisor usually leads the process. The process begins by first establishing the objectives of the exit, its timeline, understanding the owner’s intentions for the business, and the market conditions.

Objectives of the Exit: The business owner’s personal and business goals help to determine the business exit strategy, so they can prioritize specific activities, business goals, personal goals, and business objectives.

Timeline of Exit: The timeline for exiting the business guides execution of value-building strategies and maintains control over the time frame of the business owner’s exit. Allowing flexibility gives the business owner more negotiating power.

Business Intentions: Does the owner want to dissolve the business or let the operation continue? Once the owner is clear about that, they can decide whether to liquidate the business, merge it with a larger IT firm, sell it, or continue operation via succession planning.

Market Conditions: Technology disruptions are common in IT; therefore, owners must be vigilant of their products’ current demand and supply ratios as well as the marketplace demand for acquiring new IT businesses.

Do I Really Need an Exit Plan?

Yes, you do. There are several reasons for exit planning:

• Exit planning helps you understand what a potential buyer will see in your company. Scaling up profits builds the company’s value, which makes acquisition an attractive prospect.
• An exit plan addresses all aspects of a business. It takes into account everything that could impact value (e.g., people, processes, and potential). A good exit plan will help you run and build a more profitable IT company. It will reduce the company’s dependence on you, reduce risk, and improve processes and operations.
• A strategic exit plan acts as a reality check. You get clarity about what you need for yourself post-exit (monetary and security needs) and where you see your business heading in the future. Starting early is the right step in that direction.
• An exit plan also helps you safeguard your employees’ future. Suppose your exit strategy is company succession. You need to identify the key employees who can transition to new roles and responsibilities, fill in vacant positions, and tie up the loose ends. Similarly, you will also know what your next step is. Do you still want to be involved in the business as a member of its board of directors, or are you ready to withdraw from the business entirely?

What Are My Exit Options?

Once you understand your goals and needs, you must next choose the right exit strategy for your IT business. The exit options available to you include:

Management Buy-out: The company’s management team acquires all aspects of business operation and business assets. To fund the purchase, they usually pool resources consisting of personal capital, private equity financiers, and seller financing.

Internal Transition to an ESOP: An employee stock ownership plan (ESOP) ensures business continuity in case there’s no qualified management team or successor to take over the business. In this exit option, the business sets up a trust fund, and over time, some of the company stocks are allocated to the employees. Shares are distributed to individual employee accounts on the basis of their tenure with the company. As they gain seniority, they become more and more invested in the company.

Merger & Acquisition (M&A): In this exit transaction, either two companies merge to become a single business entity, or a larger firm acquires a smaller firm. There are several ways of structuring an M&A: horizontal merger, vertical merger, congeneric merger, market-extension merger, product-extension merger, and conglomeration.

Initial Public Offering (IPO): In this exit strategy, the business owner offers shares of the company to the public by issuing stocks. At the same time, the entrepreneur can raise funds from public investors. In the process, the business gradually transitions from a privately held company to a public company. In order to issue an IPO, the company must meet all the mandatory requirements defined by the Securities and Exchange Commission.

How Do I Begin?

There are three steps to planning your exit:

1. Identify when you want to exit (be specific) and how you hope to exit (internally or externally). This is the most important step: when you want to exit your business? Determining the timeline will help you get a clear picture of how much time you have to build value. What do you want your business to achieve until then? At the same time, decide the exit strategy (internally and externally) that best suits the achievement of your personal and business goals.
2. Establish the baseline value of the business. An exit plan’s main concern focuses on getting you the best price for your business, so you can leave the business on your terms. It includes action items to optimize the business value in the coming years. This involves calculating the gap between the company’s baseline value and the future value necessary to reach those exit goals. Baseline value refers to the company’s current performance (current market position, competition, and value) and is used to determine the requirements the company must meet to generate more value.
3. Execute the transition. Once your IT company has achieved its value creation target, you can execute the next step; i.e., transferring ownership of the company to the new buyer. This last phase of exit planning is where the actual negotiation is done, due diligence is conducted, and the initial sales contract is drafted. Once the deal closes in an M&A, the management teams of both the target and acquiring companies work together to integrate the two business entities.

Who Can Help Me?

Get started with the pros at Quantive. With over 15 years of experience, we can help you plan the exit that works for you.