Posts Categorized: Seller Articles

The One Number Owners Need to Stop Focusing On

The value of your business comes down to a single equation: what multiple of your profit is an acquirer willing to pay for your company?

profit × multiple = value

Most owners believe the best way to improve the value of their company is to make more profit – so, they find ways to sell more and more. As experts in their industry, it’s natural that customers want to personally engage with them, which means spending more time on the phones, on the road and face-to-face to increase sales.

With this model, a company can slightly grow, but the owner’s life becomes much more difficult: customers demand more time and service, employees begin to burn out, and soon it feels like there are not enough hours in the day. Revenue flat lines, health can suffer and relationships get strained – all from working too much. Does this feel familiar?

If you’re spending too much time and effort on increasing your profit, you could find yourself diminishing the overall value of your business. The solution? Focus on driving your multiple (the other number in the equation above). Driving your multiple will ultimately help you grow your company value, improve your profit and redeem your freedom.

What Drives Your Multiple

Differentiated Market Position

Acquirers only buy what they could not easily create, so expect to be paid more if you have close to a monopoly on what you sell and/or are one of the few companies who have been licensed to provide the specific product or service in your market.

Lots of Runway

Most founders think market share is something to strive for, but in the eyes of an acquirer, it can decrease the value of your business because you’ve already sopped up most of the opportunity.

Recurring Revenue

An acquirer is going to want to know how your business will do once you leave – recurring revenue assures them that there will still be a business once the founder hits eject.

Financials

The size and profitability of your company will matter to investors. So will the quality of your bookkeeping.

The You Factor

The most valuable businesses can thrive without their owners. The inverse is also true because the most valuable businesses are masters of independence.

 

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Valuation vs. Terms in a Business Sale

This article is provided by Brent Beshore, courtesy of Axial.net.

The following is an excerpt from investor Brent Beshore’s recent book, The Messy Marketplace: Selling Your Business in a World of Imperfect Buyers. Beshore is founder and CEO of adventur.es, a Midwestern-based permanent equity firm. 

As a seller, it can be easy to fixate on the numbers. “My business is worth X. I’m going to get Y cash at close.” These figures will represent some of the largest you’ve seen in your lifetime. The focus on valuation is understandable, but remember that structure and terms are equally important in negotiation.

When negotiating with a qualified and trustworthy investor (a.k.a. the type of buyer you probably want), you should take advantage of their expertise. While this may seem counterintuitive, they have spent their careers understanding creative ways to structure a deal, from responsible options and uses of debt to how to properly incentivize existing leadership to ensure a smooth transition. Your best path is to tell them what is important to you and why, and also what you recognize to be the risks in the deal. Then let them explain what options may satisfy both parties best. To be clear, I’m not suggesting blind trust in a buyer regardless of reputation, or your intuition. Always approach a proposed solution with open-minded skepticism.

To illustrate, here are a handful of scenarios:

QUICK EXIT: You tell the buyer that you will only consider an offer that provides all cash at close because of grave health concerns. Immediate liquidity is priority number one. You are asking the buyer to assume all responsibility and liability for not only the future prospects of the organization, but also the transition post-close. The buyer will apply a discount and the resulting valuation will likely be substantially less than a deal with more structure over a longer time period.

MARKET-BASED EXIT: You tell the buyer that you have a target valuation range, providing research that backs up why you believe it is reasonable for your business. The buyer will compare your research against their own, and also the circumstances of your company. Sellers sometimes bring forth research on industry-relevant com- panies unrelated in scale, leadership depth, and earnings history, which a buyer will quickly disregard. If the research is valid, how- ever, the buyer will likely calculate a similar valuation range (it may not be exactly the same, but they’ll tell you why) and focus on structure and terms. What percentage will be earned out to ensure performance? What guarantees will be outlined about key employees and customers?

BRIGHT FUTURE EXIT: You tell the buyer the company is set up for future growth, you have confidence in the projections provided, and, while you need some immediate liquidity, you want to share in the upside. The buyer will structure the deal to share risk and reward.

Valuation and terms for each of these exit scenarios will be varied, and that’s a good thing. They’re creative solutions. It’s key to remember what’s important to you and evaluate the options against those criteria. And above all, communicate your interests clearly.

There are no hard rules in valuation. A buyer doesn’t have to match another buyer’s offer, accept your presented adjustments, or meet your demands on timeline or payment structure in their offer. And, you don’t have to sell. Every value and formula is negotiable.

 

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EBITDA Engineering Before Selling a Business


Source: FeelPic/iStock

Takeaway: Take control of your financial statement by learning how accounting policies can positively impact EBITDA.

This article written by John Carvalho, president and founder of Stone Oak Capital Inc., an M&A advisory firm, as well as a co-founder of Divestopedia

EBITDA is a commonly used metric for the valuation of mid-market businesses. Now, the appropriateness of using EBITDA can be debated, but the fact is that most estimates of business value start with this number. So needless to say, increasing EBITDA will increase the value of a business.

Most often, business owners of privately held companies are motivated to minimize taxes. They will try to expense as much as possible and even defer recording revenue to reduce taxable income. Business brokers or investment bankers will often normalize the results of a vendor’s financial statements for nonrecurring or one-time costs. These normalizations are scrutinized by potential buyers and often rejected as legitimate adjustments. On the other hand, EBITDA (before normalizations) calculated from financial statements that are prepared by an external accountant receive much less scrutiny from the prospective buyer.

To this end, business owners should consider how their accounting policies are impacting EBITDA. The truth is that business owners can choose between various accepted accounting methods to show higher EBITDA on their externally prepared financial statement and thus positively impact business value. Some people may consider this to be financial engineering, which carries a negative connotation. I consider it to be smart exit planning.

Selection of Accounting Principles

Accounting principles are rarely black and white. There is a significant amount of gray in determining how to record a transaction. Let’s thank Luca Pacioli, the father of accounting, for the double entry system of bookkeeping that has been used for over four centuries. In its simplest form, cash outlays can be recorded as an expense on the income statement or as some sort of assets on the balance sheet. Comparatively, cash inflows can be recorded as revenue or some sort of liability (or equity) on the balance sheet. There is significant judgment and flexibility that goes into recording each transaction. This, of course, can have a material impact on the EBITDA of a business.

Here are five common accounting policy selections that can be managed to increase EBITDA:

Capital Leases versus Operating Leases

One on the biggest knocks against EBITDA as a valuation metric is that it is supposed to reflect a company’s cash flow, but it does not consider the requirement for capital expenditures. Warren Buffett, in his criticism of EBITDA, is credited as saying, “Does management think the tooth fairy pays for capital expenditures?” Regardless of your stance on EBITDA, capital asset expenditures are not considered in the calculation of EBITDA, but depreciation and amortization is added back.

If your company is capital intensive, recording equipment leases as capital versus operating will improve EBITDA. For operating leases, rental payments are expensed on the income statement and therefore reduce earnings. On the other hand, if a lease is recorded as a capital lease, the assets are recorded on the balance sheet and depreciated over time. The related liability is recorded as debt on the balance sheet and the interest is expensed on the income statement. Payments toward the capital lease are not expensed and instead are recorded against the liability which would not impact earning. Also depreciation on the asset and interest on the debt are added back, therefore EBITDA would be higher.

Capitalization

Another method to increase EBITDA is to be more aggressive on capitalization of costs, which means moving cash outlays from being recorded as an expense on the income statement to an asset on the balance sheet. This has two positive effects: The first is that it strengthens your balance sheet by showing more assets; the second is reducing expenses and increase EBITDA.

A transaction can be capitalized if it extends the useful life of a capital asset. Significant repairs and maintenance costs are often expensed in privately held businesses to reduce net income and, correspondingly, income tax at the detriment of higher EBITDA.

Costs that have future economic value that can be measured might also be eligible for capitalization. As an example, wages paid to employees for the development of a new software can be added to the cost of that implementation. Capitalization of costs is a gray area that requires just as much qualitative justification as quantitative.

Inventory

Many privately held businesses will hold inventory even though it is fully expensed when purchased. A periodic inventory count can move the inventory still sitting in the shop or warehouse off of the income statement and on to the balance sheet. This has the immediate effect of increasing EBITDA and also, from a financial reporting perspective, presents a more realistic picture of the working capital required to operate the business.

Revenue Recognition

Revenue recognition is an accounting principle that determines the specific conditions under which revenue is recognized or accounted for. Revenues are recognized when they are earned and corresponding expenses are recorded to match that timing. But when is the revenue actually earned?

Many businesses will record revenue when a project is completed, but there are many instances when partially completed jobs will straddle a company’s year-end. If revenue was recognized for the percentage of the work completed on those projects, the profit margin would be recorded on the income statement and increase EBITDA for that period.

Cut-off

Cut-off relates to whether transactions and events have been recorded in the correct accounting period. Moving certain transactions from one period to the next can have a significant impact on EBITDA. For example, delaying major purchases or taking delivery of major items after year-end can push costs to the subsequent year and thus increase EBITDA. The same is true on the revenue side if a company is able to close a major deal or make a large shipment to a customer prior to a year-end.

Own Your Financial Statement

Let me be clear that I am not suggesting perpetrating fraud or any sort of misrepresentation that could mislead a potential buyer; I am merely suggesting that selection and knowledge of accounting policies can have a significant impact on EBITDA and, consequently, the determination of a company’s value during a sale process. I see too many business owners blindly accept the adjustments that are presented to them by their external accountants. Your company’s financial statement are exactly that — yours! You should have significant input into the policies used in their creation and the ending results that they communicate to outside stakeholders.

 

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The Biggest Mistake Owners Make When Selling

One of the biggest mistake owners make in selling their company is being lured into a proprietary deal.

The Definition Of A Proprietary Deal

Acquirers land a proprietary deal (or “prop deal”) when they convince owners to sell their businesses without creating a competitive marketplace. Acquirers running a proprietary deal know they don’t have any competition and tend to make weaker offers with more punitive terms because they know nobody else is bidding.

Many founders become the target of a proprietary deal without even knowing they have been duped. First, someone senior from the acquiring company approaches the founder, complimenting them on their business. The acquirer suggests lunch, and then high-level financials are exchanged. Soon, the owner starts going down a path that is difficult to come back from.

As the parties in a proprietary deal get to know one another, founders often share information with the acquirer that puts them in a compromised negotiation position. The interactions are set up as friendly exchanges between two industry leaders, but many founders reveal key facts in these discussions that end up being used against them when negotiations turn serious. Business owners also become more emotionally committed to selling the more resources they invest in the process and the more time they spend thinking—perhaps dreaming—of what it would mean to sell their business.

How To Avoid Getting Taken In By A Proprietary Deal

Savvy sellers avoid the proprietary deal by creating a competitive process for their company. Take for example Dan Martell, the founder of Clarity.fm, among other companies. When Martell decided to sell Clarity, he knew the likely buyer was one of five New York-based companies. Instead of negotiating with one, he invited all five to an event he hosted in New York. The five CEOs—all of whom knew one another—saw a room full of their competitors and realized that if Clarity went on the market, they would have to out-bid the other buyers in that room.

Hosting the event was Martell’s way of communicating to all the potential buyers that a proprietary deal was off the table and that if they wanted to buy Clarity, they would have to compete for it.

It’s flattering to receive a call from an executive at a company you respect. Just know that if you accept their invitation of lunch, you run the risk of becoming the latest casualty of the proprietary deal.

 

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The Initial Price May Not Be Real

The following article written by Paris Aden of Valitas Capital Partners.

Takeaway: The Due Diligence Grind is often practiced by sophisticated acquirers to reduce the purchase price of a business by citing negative findings during due diligence.

The initial dollar figure presented as a purchase price for a business, whether written on a napkin over coffee or floated in a conversation, is not a binding offer. Any potential acquirer will need to conduct a due diligence investigation before they can enter into a definitive agreement to buy your business. Initial indications can be tactically inflated to ensure the acquirer gains access to your confidential information after which this price is systematically reduced, citing negative findings during due diligence — also known as “The Due Diligence Grind”. The most effective antidotes are preparation and competitive tension. Let’s take a closer look at how a prospective buyer can grind down the purchase price.

Due Diligence Becomes a Reactive Process for the Seller

Whether you have received a preliminary proposal from a single party who approached you or you’ve received several non-binding bids through a structured auction process, the nature of the process changes from proactive to reactive as due diligence progresses. Ultimately, each bidder will have different due diligence requirements and the onus is on the seller to satisfy those requirements (or not). The due diligence stage is the acquirer’s opportunity to investigate the business from top to bottom. Although difficult, it is essential to maintain control of the process, despite your reactive position during this phase of the process.

How Due Diligence Increases Transaction Risk and Impacts Valuation

The purpose of due diligence is for the acquirer to conduct his or her own assessment of the value of your business and to confirm their initial assumptions. As you submit information about your business to a potential acquirer, they will investigate potential risks, including validating information that may have been presented to them earlier in the process. Due diligence is an essential step for the acquirer to make a binding commitment to a price and to inform the negotiation of the definitive agreement. However, savvy acquirers are skillful at gaming this process to their advantage.

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Potential acquirers can by cynical. A key due diligence objective is lowering the price of the business by focusing on its flaws. Imagine a customer listing a litany of complaints or deficiencies about your product or service as you are presenting your case for a routine pricing increase. Potential acquirers may attempt to reduce the value of the business either explicitly, by reducing the headline price or, indirectly, by revealing transaction terms that erode the value you receive.

Headline Price Adjustments via Valuation Metrics

Private businesses are routinely valued as a multiple of a particular financial metric. One of the more commonly used metrics is earnings before interest, taxes, depreciation and amortization (EBITDA). Adjustments are commonly applied to normalize EBITDA for what it would be in the hands of the new owner. These metrics are reported as part of the preliminary documentation and are scrutinized heavily during the due diligence process. The acquirer will typically seek to expose weaknesses in the information and rationale for the normalization adjustments to make a case that the metric is inflated. A few examples include:

  • Accounting Policies: Suggesting accounting policies, such as revenue recognition, allowance for doubtful accounts or capitalization policy are too aggressive.
  • Normalization Adjustments: Suggesting that non-recurring normalization adjustments really are normal-course business, that market value of the owner’s compensation is understated, that certain expense savings really are buyer synergies that are not appropriate for stand-alone valuation.
  • Budgets and Forecasts: Often the valuation is based on a forward metric, such as forecast EBITDA. The seller’s forecast assumptions may be deemed too optimistic, or as we Canadians like to describe it, a “hockey stick forecast”, where projected growth is out of line with historical growth.

Given that the headline value is simply the product of the valuation metric and the valuation multiple, a reduction in the metric will have a proportionate impact on the headline price.

Headline Price Adjustments via the Multiple

Though less common that a negative revision to the metric, a bidder may suggest they have justification to reduce the multiple they have applied in their initial valuation assumptions because of newly identified/revised risks that they claim they were not aware of earlier. There are generally four reasons the valuation multiple may be reduced, the first three of which are specific to the business:

  1. Greater business risk, such as poor quality of earnings;
  2. Lower expected growth as a result of improperly supported growth forecasts;
  3. Reduced free cash flow conversion expectations, such as higher than expected capital expenditure or working capital requirements; or
  4. Deterioration in market conditions, such as a drop in capital markets valuations or tightening credit.

Adjustments to the Transaction Terms

Negative revisions can also manifest in the deal terms. This can be more difficult to control because such details are usually ignored as part of the “business deal” and left for the lawyers. The acquirer may claim due diligence findings that require terms that either erode the value of the headline price or significantly shift risk to the seller. Examples include:

  • Shifting Risk to the Seller: Out-of-market representations and warrantiesindemnities or hold-backs. For example, an acquirer may agree on the ‘price tag’ of the deal, but add a condition that if the seller misses the five-year forecast by one dollar, the price paid will be reduced by 50%.
  • Changing the Form of Consideration: That firm cash price may become payable in IOU’s and store coupons. A portion of the price may become contingent on performance of the business post-closing, i.e. as an earnout.
  • Working Capital: This one is a favorite! Instead of delivering the business with a level of working capital appropriate to operate the business in the normal course, you are presented with a convoluted adjustment mechanism that suggests the business should be delivered with more working capital than needed, resulting in a negative price revision for you post-closing. Or the most egregious of working capital manipulation, the cash dam.
  • Effective Date: Seems innocent enough. Let’s make the effective date at the beginning of this year. The problem is that all of that free cash flow from the effective date until closing now belongs to the acquirer. Another effective reduction in the purchase price.

 

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