Q3 2016 M&A Update: Earn-outs: Uses, Pitfalls, and Opportunities

Earn-outs: Uses, Pitfalls, and Opportunities

What is an "Earn-out" as it relates to the sale of a business? An earn-out is a contingent payment agreement whereby the buyer agrees to pay additional money for the business upon the attainment of certain post-closing performance targets. An earn-out is a financial tool used to bridge the gap between the seller's price expectations and the buyer's perceived value for the business. The most common reason for a gap between the offer and the seller's price expectations results from the two parties to the transaction having differing views of "business risks." The sale of a business is extremely complex, and involves risk factors related to revenue, customer retention, the management team, and many others, which are viewed through different lenses by the buyer and seller.  

Let's remember - in an "all cash" purchase, the buyer has all the risk, therefore the selling price will usually be at the lower end of the spectrum. In a transaction with cash plus a promissory note to seller, there is some level of risk tied to the promissory note - so the seller can justify a price that is a bit higher than "all cash." If an earn-out is included in the transaction structure, the seller expects to receive more for their business, but the last piece of the consideration is tied to future events, so both parties share the risk.

Earn-out structures will be very specific to each transaction. A typical earn-out structure may start with "If revenue in year #1, year #2 and year #3 after closing is equal to or above these targets,  "X", "Y", and "Z", then the seller is paid a certain amount each year."  As simple as that concept sounds, each earn-out structure will be as unique as the business itself. Many times the seller wants the earn-out tied to gross revenue, while the buyer typically wants the earn-out tied to EBITDA. At that point, the negotiation begins, and the actual measured performance often ends up tied to a metric somewhere in between revenue and EBITDA. In our experience, the least amount of computations that must be made to compute the earn-out will result in the most desirable structure.

Our firm recently represented the seller in a transaction whereby approximately $6,000,000 of the price was fixed, and another $3,000,000 of the consideration was based upon an earn-out tied to gross profit earned each year for the first twenty four months after closing. This company was in a cyclical industry, and the seller believed that the industry would maintain their momentum for several years. The buyer was not willing to pay the full price without some part being tied to future performance. The seller was willing to stay with the business through the term of the earn-out, to insure that it would be met. This client has now collected the targeted payments for year one, and is now completing year two.

One tip to remember is that earn-outs should not be "all or none," but rather based upon incremental levels of the performance metric. They should also be structured whereby meeting the target on a cumulative basis over multiple years will still trigger payments, even if one year was below the target (a "lookback provision").

Our firm does not begin marketing a business with an earn-out in mind, but it may be an appropriate financial tool used to facilitate a transaction in certain situations. Earn-out structures are complex and require the seller to evaluate the risk they are willing to assume in utilizing that structure to achieve the maximum consideration. A seller will need an experienced M&A professional and transactional lawyer to carefully negotiate the earn-out and make sure their agreements are well drafted.

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Multiples of EBITDA – What Factors Turn a 3x into a 5x?

We all know that “money doesn’t grow on trees.”  And neither does business value.  You can’t just wait until you are ready to leave your business to find out how much “value” you need or want and how much “value” exists in your business.  By then it will be too late.  The tree metaphor is relevant, though.  Value is something that you can grow, nourish and ultimately harvest in your business.  Let’s look at an example.

Picture three identical companies each engaged in moving time-sensitive freight for customers. All have a national presence, $2M in EBITDA (Earnings Before Interest, Tax Depreciation and Amortization) and about $25M in annual sales. It would be logical to assume that they all have about the same value. 

In fact, one had little value, one sold for 3.5 times EBITDA and one sold for 5.5 times EBITDA.  The difference in value was $3M to $7M to $11M.

Neither gross sales nor EBITDA alone determined the price and terms of these deals.  The key to the variation in purchase prices was the presence or absence of value drivers in the companies as well as the ability of these value drivers to survive the owner’s departure.

Value drivers are internal characteristics of a company that buyers look for in acquisitions. You’ll see that it doesn’t matter if you plan to keep your business forever, transition it to family members, sell it to your management team or find an outside buyer - value drivers can give you more options, more flexibility and more money from your ownership interest. Strong value drivers are those that are effective and will continue to operate once the original owner departs.  Consequently, those are the value drivers that increase both EBITDA and the multiple of EBITDA buyers may be willing to pay.

We may measure the effectiveness of value drivers in two ways:  1) their positive contribution to cash flow and 2) their ability to continue to contribute to cash flow under new ownership.

Think of it this way: why would anyone want to buy your business if its continued success is dependent on you-the departing owner? Buyers are more likely to pay top dollar for businesses that will not miss a beat when the original owner is no longer in charge.

Success in business is determined not by how well you run the business, but by how well the business runs without you.

Let’s look at the three freight-moving companies more closely to see what motivated buyers either to open their wallets or walk on by.

Company A:  The owner/operator was responsible for management, operations and his personal and industry contacts were the source for new business. All roads ran through the owner so without him, the business had little value.

Company B:  This company had a capable management team.  Many of its systems and procedures were state-of-the-art.  There was, however, one glaring weakness: the major customer, responsible for over 50 percent of the company’s revenue, had a decades’ long relationship with the company’s owner, not with the company.
Buyers are much less likely to pay millions for customer accounts that can, and indeed often do, go elsewhere the day after they find out the owner has sold the business.

Company C:  Finding the owner of Company C wasn’t easy.  She spent weeks on vacation or visiting grandchildren and when she was in town, was engaged in a variety of civic and charitable activities.  She made workplace appearances only sporadically and left operations in the hands of her stable, effective management team.
She had deliberately created plenty of diversification in her company’s customer base knowing that one day she’d sell the business.  She had thought about what she would look for in an acquisition so had included customer diversification as one of many attributes or value drivers she wanted in her company. She understood that value drivers were necessary to maximize sale-ability as well as the sale price and amount of cash she could demand from a buyer.

Interested buyers were delighted that she had changed her role in the company over the years so that a new owner could step in, almost unnoticed.  

There are a number of value drivers that are critically important to today’s buyers.  The value drivers that are most important to your business may or may not be the same as those that were identified for Company C.  What we can say with some certainty is that value drivers can help your business value grow to bring you closer to the value that you need.  If you are interested in learning more about them, we will be happy to sit down with you and talk about how value drivers might improve your business value.

Corporate Investment is unique in that we take a holistic approach to working with business owners. Exit planning is a part of our process. We help business owners plan for one of the biggest financial events of their lives - the transition out of their business. 

For more information on exit planning services - please contact one of our professionals at Corporate Investment.   512-346-4444 

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The information contained in this article is general in nature and is not legal, tax or financial advice. For information regarding your particular situation, contact an attorney or a tax or financial advisor. The information in this newsletter is provided with the understanding that it does not render legal, accounting, tax or financial advice. In specific cases, clients should consult their legal, accounting, tax or financial advisor. This article is not intended to give advice or to represent our firm as being qualified to give advice in all areas of professional services. Exit Planning is a discipline that typically requires the collaboration of multiple professional advisors. To the extent that our firm does not have the expertise required on a particular matter, we will always work closely with you to help you gain access to the resources and professional advice that you need. Any examples provided are hypothetical and for illustrative purposes only. Examples include fictitious names and do not represent any particular person or entity. 

Corporate Investment adds Exit Planning Services for business owners.

Since 1984, our firm has worked with business owners in over 250 business sale transactions. These businesses had between 10 and 250 employees. Unfortunately, we found that prior to meeting us, very few of our clients had a well-defined, well-executed strategy for the transition out of their business. They had not taken the time to develop a plan to address issues like:

• How much longer did they want to work in their business?
• How much annual after tax income would need during retirement, and where was it going to come from?
• What would happen to the business, and their family members who relied on it for their livelihood, if an unforeseen event happened and they couldn't work? 

Most business owners have not taken the time to understand that there are ONLY three options for their transition out of their business:     

• Transition to Insiders ( family or employees )
• Sale to Outsiders
• Transition after Death of Owner to their estate, leaving it to their heirs to handle

Each of these paths has its own unique set of issues and tax concerns that must be addressed well in advance of the transition. The process of addressing these concerns is aptly named "Exit Planning." All three options depend upon converting the business value to cash in some manner, over some period of time. The sooner a business owner identifies their objectives, engages advisors, develops a plan and takes action to implement that plan, the more control they will have over the outcome. A universal ownership objective is to generate an income stream that you ( the owner ) and your family will need  to support a future lifestyle.

We also found that all of our business owners had one thing in common: "I want to receive the highest value for my business!" Value in this context may include not only the actual price, but other objectives such as minimizing risk, minimizing taxes, and insuring a successful transition of the business (whether insiders or outsiders).

The business owner's objectives form the basis of the plan, and while each business and owner has a unique set of facts, the defined process means the business owner does not have to reinvent the Exit Planning wheel themselves. The owner's clearly defined objectives will direct the planning and actions, and help optimize the net proceeds. A team of advisors, which includes an attorney, CPA, financial planner, insurance professional and M&A advisor, will support and guide the business owner throughout the process.  Our firm will coordinate the team of advisors on behalf of the business owner, to maintain accountability and progress towards the owner's successful outcome.

We help our business owner clients plan for the most critically important financial event of their lives – the transition out of their business.

Find out more about our exit planning service.

       "In any moment of decision, the best thing you can do is the right thing. The worst thing you can do is nothing."  

Theodore Roosevelt

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Creating value in your business to get top dollar when you leave it

Did you ever wonder why one business has buyers lined up willing to pay top dollar while another sits on the market for months, or even years? What do buyers look for in a prospective business acquisition?

There are many opinions about what attributes or characteristics buyers seek, but here’s what we know: the characteristics buyers seek must exist before the sale process even begins and it is your job as the owner to create value within your business prior to the sale. We call characteristics that impact value “Value Drivers.”

Walk A Mile In A Buyer’s Shoes

To get an idea of the importance of Value Drivers when preparing to sell your business, it is important to put on the buyer’s shoes for a minute. Let’s look at a hypothetical case study that illustrates how a buyer might compare two similar companies with a different emphasis on Value Drivers.

The A Factor Company has EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of $2 million, an owner who runs the business and the systems and processes that create growth. The A Factor Company doesn’t have a real management team in place and the owner generates a majority of its sales. The owner is the center point of the company, holding both the CEO and CFO positions. With this level of responsibility, the owner is burning out quickly.

In comparison, The B Factor Company also has EBITDA of $2 million and a solid management team that runs the business, systems and processes. The management team creates efficiencies within the business and the owner vacations for six weeks a year.

If you were a buyer comparing these two companies, which would provide a more attractive business opportunity? How much more would you pay for a business with a strong management team (one of the most important Value Drivers)? Would you even be interested in buying a business whose management team (the owner) walks out when you walk in?

Investment bankers understand that companies that lack strong Value Drivers also lack a bevy of buyers. Those buyers that do come to the table do not arrive with pockets full of cash.

Let’s look at several of the more important Value Drivers common to all industries:

• A stable and motivated management team. If you can wait a year to sell your business, we suggest that you consider an incentive compensation system, cash or stock-based, that rewards key employees as the company performs (usually measured by increases in pre-tax income). Sophisticated buyers know that with a solid management team in place, prospects are good for continued business success. Without a strong management team, it may be very difficult to sell your business to a third party or transfer it to an insider.
• Operating systems that improve sustainability of cash flows. Operating systems include the computerized and manual procedures used in the business to generate its revenue and control expenses, (i.e. create cash flow), as well as the methods used to track how customers are identified and how products or services are delivered. The establishment and documentation of standard business procedures and systems demonstrate to a buyer that the business can be maintained profitably after the sale.
• A solid, diversified customer base. Buyers typically look for a customer base in which no single client accounts for more than 10 percent of total sales. A diversified customer base helps insulate a company from the loss of any single customer. If the majority of your customer base is made up of only one or two good customers, consider reinvesting your profits into additional capacity that will make developing a broader customer base possible.
• A realistic growth strategy. Buyers tend to pay premium prices for companies with realistic strategies for growth. Even if you expect to retire tomorrow, it makes sense to have a written plan describing future growth and how that growth will be achieved based on industry dynamics, increased demand for the company’s products, new product lines, market plans, growth through acquisition, and expansion through augmenting territory, product lines, manufacturing capacity, etc. It is this detailed growth plan, properly communicated, that helps to attract buyers.
• Effective financial controls. Financial controls are not only a critical element of business management, but they also safeguard a company’s assets. Effective financial controls support the claim that a company is consistently profitable. The best way to document that your company has effective financial controls and that its historical financial statements are correct is through a certified audit or perhaps a verified financial statement by an established CPA firm.
• Stable and improving cash flow. Ultimately, all Value Drivers contribute to stable and predictable cash flow. It is important, especially in the year or so preceding the sale of the business, that cash flow be substantial and on an upswing. You can begin increasing cash flow today by simply focusing on ways to operate your business more efficiently by increasing productivity and decreasing costs.

You can install these Value Drivers and better position your company to secure a premium price upon your exit with the help of a trained Exit Planning Advisor. Find out more about exit planning today.

http://www.corpinvest.com

A race against time: Exit Planning

Successful, active business owners seldom slow down. Many business owners are both great at planning (for their businesses) and terrible at planning (for themselves).  There are so many great business challenges to tackle, planning for your personal ownership future can get pushed to the back burner.  We all know that the only things likely to reduce your pace are death or terminal burn-out. This is not to imply that you are not well intentioned; quite the contrary. You may be so well intentioned that you’ve taken on more responsibility than you can possibly complete.

Today, our goal is not to alter the number of hours in your workday but to alter your mindset. To do that, let’s look at a fictional business owner.

Renaldo LeMond owned a growing hospitality services business. As business increased, he hired more employees and learned to delegate. Both these improvements freed up time to sell more, to manage more, and to grow the business more.

No matter how much Renaldo delegated, there were always additional tasks and new priorities. Renaldo’s daily activities left no time to plan. Even if he had had the time, Renaldo really didn’t know how to create a plan founded on a clear vision, backed by definite plans that created definable steps subject to deadlines and accountability.

This was Renaldo’s situation when he was approached by a would-be buyer for his business. Renaldo hadn’t actively considered selling his business, but at age 49, he was beginning to think that life after work might have something to offer. He was open to talking about and exploring the idea of selling his business because business growth, and more importantly, profitability, had been slowing for years.

Renaldo found an hour in his schedule to talk to the interested buyer. In only 60 minutes, Renaldo’s blinders were removed and his priorities were turned upside-down.
The buyer turned out to be a large national company seeking to establish a presence in Renaldo’s community. It was interested in Renaldo’s business because of its reputation as well as its broad and diversified customer base. The buyer was looking to acquire a business that could grow with little other than financial support.

Naturally, it sought a business with a good management structure because, like most buyers, it did not have its own management team to place in the business. Renaldo, however, had not attracted or retained solid management (nor had he created a plan to do so). His business lacked this most basic Value Driver.

Like many buyers, this buyer also looked for two additional Value Drivers: increasing cash flow and sustainable systems throughout the organization (from Human Resources to marketing and sales to work flow). Renaldo quickly realized that his business was a hodgepodge of separate systems each created to patch a particular problem.

Finally, the buyer asked Renaldo to describe his plans for growing the business. Renaldo had none. What this buyer and Renaldo now understood was that this business revolved around Renaldo.

As Renaldo left the meeting, he expected that, given his company’s deficiencies, he would receive a low offer from the buyer. He waited weeks but no low offer was forthcoming. In fact, the buyer simply disappeared.

The message to all of us is clear: Unless a business is ready to be sold, many buyers, especially financial buyers, are not interested. They have neither the time nor the in-house talent to correct deficiencies. The look for (and pay top dollar for) businesses that are poised for ownership transition.

It is a fact of life for owners that unless you work on your business, rather than in your business, you will never find time to plan for your future and for the future of the business.

Is there a way to change your priorities before your 60 minutes with a prospective buyer? Of course. You simply acquire new knowledge (about Exit Planning) and apply it to your life.

Exit Planning requires time: time not only to create the plan but also time to implement it and to achieve measurable results. That timeline may be considerably longer than you anticipate because, in creating an Exit Plan, you need to rely on others who are also busy (minimally an attorney, CPA, and financial planning professional). Additionally, you can not anticipate all of the issues that might arise, and it is unlikely that everyone you work with is as motivated or experienced as you are. Finally, and inevitably, not everything will go as planned.

Exit Planning encompasses all sorts of planning: your growth, strategic, tactical and ownership succession planning for your business, as well as your personal financial, and estate planning. By wrapping business, estate, and personal (or family) planning into one process, Exit Planning is all-encompassing rather than a subset of the planning that you are sure you will one day undertake. In short, there is much to do.

It may be helpful here to recognize that planning, properly undertaken, can help enrich your business as well as your personal life. According to Brian Tracy, "A clear vision, backed by definite plans, gives you a tremendous feeling of confidence and personal power." And, in the case of Exit Planning, it works, too. Find out more about exit planning.

The example provided is hypothetical and for illustrative purposes only. It includes fictitious names and does not represent any particular person or entity. Copyright © 2016 Business Enterprise Institute, Inc., All rights reserved.

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Q1 2014 M&A Market Update

As we complete the first quarter of 2014, we have seen several trends develop in M&A that are impacting valuations, as well as the number of sale/recapitalization transactions of closely held businesses. In 2013 and Q1 2014, we closed numerous transactions across the state, in varied industry sectors, including an Austin-based client company that was acquired by a public company based in Europe. Our opinion is that the M&A market is extremely favorable to sellers today. This was reinforced by a recent article by Andy Greenberg, CEO of GF Data, who stated:

"The primary drivers of middle-market deal flow - company and industry performance, capital availability, macro-economic conditions, and public equity values - are more favorable to the private business seller than at any time since the mid-2000s, but the volume of change-of-control deal activity is just not on par with these favorable market conditions."

In addition, an article in the New York Times on February 11, 2014, contained the following:

"The market is further constrained by a lack of companies willing to sell, as they wait for the economy to improve further", said Milton J. Marcotte, head of the national transaction advisory services practice at McGladrey, an accounting, tax and consulting firm for private equity. "That intensifies competition among buyers. We've been doing this awhile, and I don't remember a time when it was really quite this competitive," said Mr. Marcotte.

We also know from our industry sources that private equity firms are collectively sitting on about $1 trillion in capital that they must invest. So, with well-capitalized buyers in the market, what is holding back sellers of closely held businesses? We believe that many sellers are skeptical when we discuss what is clearly a "sellers' market". They have heard this before. However, we can verify that multiple offers for good businesses, especially in Central Texas, is the norm rather than the exception.

So, is now the time for business owners to ask themselves if it is a good idea to have a significant amount of their net worth tied up in their privately-held business? We have noticed businesses have recovered from the 2008-2009 recession, and now the business is doing quite well, and thus, the owners ask "why sell now?" Unfortunately, history shows that recessions happen in 7-10 year cycles, and most of us cannot predict the future very well. Selling at the top may have appeal as the smart move. But we know that it is difficult to accurately predict the ideal time. Our message to business owners is don't wait for uncontrollable factors, such as health issues or other personal factors, to force you into an exit strategy. The better course of action is to take control and plan your exit in a way that maximizes value. We believe that the only way to maximize value upon the sale of a privately held business is to run a well-managed process that leads to multiple offers.

So if it's a "sellers' market", what impact is that having on valuations? It varies, of course, by industry and size of company, but some broad parameters do apply. The following appeared in the GF Data article:

"The non-institutionally-owned businesses offering neither above-average financial characteristics nor a management solution post-close that continued the march towards closing in the first months of 2013 traded at an average of 4.4 TTM Adjusted EBITDA."   GF Data, March 2014.

Two salient points in that statement: These businesses were neither above average, nor did they have a strong management team after acquisition, yet were still getting a multiple of 4.4 times TTM Adjusted EBITDA. So if a business has better than average financial performance and a solid management team, it should command an even higher multiple. This is supported by a recent New York Times article, in which David Humphrey, a managing director at Bain Capital, noted:

"Valuations for clean, easily extractable businesses are quite high."

So going forward in 2014, we expect continued high demand for Central Texas businesses with upward pressure on pricing for well-managed, profitable businesses. There were over 150 Private Equity Groups at the recent ACG conference in Houston, intensely focused on finding solid acquisitions of both platform and add-on businesses.

Please do not hesitate to contact us for specific information about market trends.

http://www.corpinvest.com

What factors determine the "Multiple" of earnings?

A "multiple" of earnings is a valuation method whereby the value of a company is expressed through the use of a multiple applied to the Company's earnings.  For instance, a company that has Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) of $2,000,000, that has a "value" of $10,000,000, was valued at  5 x EBITDA. The appropriate earnings multiple that should be used to value any particular company depends upon a number of factors, or attributes.  One way to drive a higher value for your company is for it to possess some of those attributes that warrant a higher earnings multiple.  Predictability of revenue, sometimes referred to as "stickiness" of revenue, is one of those attributes that impacts the earnings multiple.

Companies with highly predictable or recurring revenue streams sell for much higher multiples than companies whose revenue is not recurring, or is dependent upon constantly generating transactions with new customers for its revenue stream.

Some of the factors that demonstrate a higher level of predictability of revenue include:

• Contractual agreements with customers for repetitive sales of goods or services, such as manufacturing companies with long term purchase orders, or service companies that have annual recurring service contracts.
• Operating in an industry where the barriers to entry are high. 
• A solid and growing customer base with very little turnover.
• Serving a market, either industrial or geographic, that is growing. 
• In the case of distribution companies, protected territories or exclusive rights to product lines.
• A revenue model that resembles a razor/ razor blade concept - where customers are "locked in" to a company's product or services. 

Factors that indicate revenue is not highly predictable include:

• The majority of the customer relationships are managed by the owner of the business, or a small group of sales executives (the risk being that if the owner is no longer involved, or if the sales executives leave, the customer base may no longer have loyalty to the company). 
• The barriers to entry are low - new competitors can easily enter the market, thus increasing the competitive landscape. 
• Revenue is project dependent. 
• There are pricing risks, either from changing technology or governmental regulation.

There are many other factors that come into play, way too many to outline in this article. As a business owner, we recommend that you review the sources of revenue for your company and, if possible, take steps to improve the "stickiness" of your company's revenue stream.

In future articles, we will discuss other factors that impact a company's earnings multiple, such as strength and depth of the management team, the company's operating systems, reliability of the financial reporting system, opportunities for growth, the make-up of the customer base, intangible assets, strength of cash flow, scaleability, the amount of capital investment required to sustain or grow a business and preparedness for the due diligence process.

If you have any questions or would like to discuss your particular company and how you can improve your valuation multiple, contact us, we would be happy to share our knowledge with you.

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Five Key Issues to Address in a Business Sale Transaction

These five issues are key to consider when you are contemplating selling your business.

1. Non-Disclosure Agreement

This agreement contains a few key elements that may easily be overlooked by an uninformed Seller. The first of these is the “non-solicitation” of employees, which should be coupled with a time frame of a minimum of two years, we suggest three years. A second important provision will state that “all obligations under this agreement shall survive for a period of ___ years (we suggest three), except that sections _ , _, _, and _ shall continue at all times. One of these specifically enumerated provisions states that the entire discussion must remain confidential. When a business owner goes to market, if they do not sell, they surely want that fact to remain confidential, even after two years, so this provision is extremely important. Buyers sometimes strike this provision, and a Seller must understand its importance.

2. Excluding Certain Types of Buyers from the Marketing Process

The goal of the business owner is to receive maximum value in the sale of their business. Strategic buyers typically pay a premium of 10% – 20% ( or more ) than pure financial buyers. A Seller should let their M&A professional contact the universe of qualified acquirers, including strategics, to insure that they receive the maximum value. If strategics are not included in the marketing effort, the Seller will never know if they received the highest price that was possible.

3. Letter of Intent – Timeline

One of the pitfalls that a Seller may experience when dealing with only one buyer, is the buyer’s total control of the timeline of the transaction. “Time is the enemy of a transaction.” That is not to say that the parties should rush to closing, but stretching out the timeline of due diligence and closing typically benefits the buyer, not the seller. The letter of intent should include a timeline of critical dates for important milestones, such as confirmation from the bank that a loan is approved, date for buyer to deliver initial contract draft, and closing date. The letter should contain language that the binding provisions of the LOI are contingent upon the buyer’s adherence to the timeline.

4. Letter of Intent – No Shop Provisions

Most Buyers insist upon a “No-shop” provision in the letter of intent. The Buyer is committing time, energy, paying CPA’s and attorneys, and as a reasonable request, typically asks the Seller for exclusivity (as long as the timeline is met !). However, many Buyers will include an additional sentence in the no-shop provision that the Seller must inform the Buyer if they are contacted by another party during the due diligence period, including the name of the potential buyer. We do not recommend our clients accept this specific provision.

5. Contacting Employees Early in the Due Diligence Process

Many Buyers will ask to speak to key employees early in the process – this should not happen. Discussions with key employees should only occur after financial due diligence is complete, a draft of the contract is received, evidence that financing is in place is received, and we are at the 11th hour. The Seller should always attend these meetings, which can be an issue for the Buyer. This is an extremely sensitive issue and must be handled carefully.

Considering selling your business? Corporate Investment can advise you in how to start the process.

http://www.corpinvest.com

Ten Ways to Maximize the Value of Your Business

Achieving the maximum value for the business when it sells is the goal of every business owner. These ten ideas can help you see if you are on the right track.

1. Develop a strong, stable management team

A business with a strong management team, allowing for key activities to operate independent of the owner, will command a higher price. The depth and stability of the management team are extremely important factors in the valuation analysis by a buyer. In many businesses, sales and marketing may be very dependent upon the owner, and this can be a significant value detractor. If most of the key account relationships reside with the owner, buyers will factor this risk into the valuation or the deal structure. Part of the price may become contingent upon the owner remaining with the business to maintain continuing customer relationships.

2. Demonstrate sustainability of earnings

Revenue and earnings that have been steadily growing over several years, versus earnings that fluctuate dramatically, will drive a higher valuation. Year over year growth demonstrates a solid operation that is gaining new customers and/or market share. Dramatic fluctuations in revenue typically indicate that either product demand may be subject to outside factors, or the business has experienced problems, indicating management is not stable. Recession proof businesses have been commanding very strong multiples in the market over the past three years.

3. Develop systems and procedures

A business must exist separate and apart from the daily actions of its owner to have a valuation, including goodwill, over and above the asset valuation. An owner who takes a week off at least one or two times per year, is exhibiting confidence in the systems and procedures of the business to function while they are away. If the owner is seldom or never away from the business for any length of time, buyers will question the strength of the operating systems, and the management team. The amount of goodwill that a buyer is willing to include in the purchase price will be dependent upon systems and procedures.

4. Maintain excellent financial records

Sloppy financials are a worry for both buyers and lenders. Valuation will be based primarily upon the numbers, and the more reliable the financial statements, the more chance they will hold up in due diligence. If your business has revenue in excess of $10,000,000, audited financials will be worth the investment. In the absence of audited financials, reviewed financials are preferable over internal financials, as the presentation, account classifications, footnotes, and organization of the statements, in general, will be much more professional than internally prepared financials. Most purchase agreements will contain a representation that  “Seller’s financials are presented in accordance with GAAP”. We routinely ask for this representation to be reviewed very carefully, as the majority of private company financial statements do not contain all the disclosures required by GAAP.

5. Minimize personal expenses paid by the business

When the financials are “clean,” with very few “add backs” related to owner’s personal expenses paid through the business, buyers and lenders believe the numbers are more credible. Asking a buyer to believe that various expenses that have been paid by the company are in fact “not necessary” for the business creates uncertainty. Uncertainty is the enemy of a successful sale transaction. When the EBITDA computation is partially based on excessive “add backs” to earnings, the seller will be hard pressed to obtain a favorable valuation.

6. Transition Planning

When a seller has a definite plan to “phase out” of the operation, whether that is over one year, or three to five years, the buyer recognizes that sound planning has occurred. The process of developing this transition plan will often generate excellent suggestions for improvement in management’s role in the everyday operations of the business. Many sellers begin to outline their “job description” as part of this process, which highlights areas where there is a need to delegate more to the management team. Quite often this activity will result in improvements to the organization structure of the business and produce tangible benefits.

7. Diversified Customer Base

Customer concentration is a significant value detractor. When the revenue from any one customer accounts for over 20-25% of the total revenue of the business, the business will be valued at a discount.  Losing 20-25% of revenue in most businesses will typically wipe out most or all of the profit of the operation, so this risk may not be ignored.  When the buyer’s valuation is prepared, and this risk is factored into the valuation analysis, the goodwill included in the valuation of the business will be dramatically altered. Working to diversify the customer base will result in significant increases in the value of the business.

8. Solid Reputation in the Marketplace

Business acquirers are constantly searching for the leading business in the industry, and many sellers refer to their business as an “industry leader”. Savvy buyers can mine the internet for information about what customers actually think about most businesses. Multiple websites exist that give “feedback” from customers about businesses, and buyers may gather this data easily.  Buyers will attend trade shows, industry conferences, and multiple other events, quietly asking competitors and suppliers about a company, using multiple techniques to determine what customers think about a business.

9. Diversified Base of Suppliers

A very narrow base of suppliers, or extreme dependence upon one supplier, may cause a decrease in valuation. Many business owners routinely buy from multiple sources, just to manage the risk that one supplier may experience shortages or interruptions in supply. This extends to the labor pool as well, if the business needs specialized skills, such as in healthcare. “What happens if…” is a typical question a buyer may ask – and many sellers do not have a ready answer for that question.

10. Stable Facility of Operations

A business may or may not be dependent upon its location, but a buyer will not want to take the risk of moving the business right after the purchase. The business should have the right to remain in their current facility for at least 3 – 5 years through an existing lease, or ownership of the building.  The location may be critical to a retail operation or restaurant, but also important to a wholesale or manufacturing operation. Many times key employees live close by, and the buyer having to relocate the business may place loyal employees in peril. If the lease is about to expire, and the buyer will have to renegotiate the lease right after closing, this situation creates uncertainty, which reduces the valuation. Lease options are an excellent method to remove this uncertainty, whereby the business has the right, but not the obligation to extend their lease beyond the current term.

For more information on maximizing the value of your business, contact Corporate Investment.

http://www.corpinvest.com