Your Business – From a Buyer’s Point of View

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When you sell your business, you want to do everything possible to get the right price. That often means forgetting about how you have run the business, and looking at it from the buyer’s point of view.

What the Buyer is Buying

Generally speaking, a buyer will be willing to pay a price that is a multiple of the company’s annual cash flow. The multiple varies widely depending on the industry, the economy and many other factors. The price the buyer pays, though, will be a multiple of his expected cash flow – not yours.

The harsh fact is that the buyer doesn’t care how you ran the business. Certainly, he will keep what he sees as the best practices and procedures, and will probably keep most of your people, but his ideas on executive compensation, business development, human resources, inventory control, and a host of other subjects will probably differ from yours.

I actually saw a deal fall apart because the seller insisted on dictating how the business would be operated AFTER he was gone.

The trick is to know what the buyer believes he is buying.

Normalizing Results

It’s a useful exercise to adjust historical earnings for unique, unusual or non-recurring items, so future cash flow projections reflect the results the buyer is likely to achieve. This is called “normalizing” cash flow. Depending on how you’ve been operating the business, this process may identify certain assets or liabilities that should be valued separately.

Here are some examples:

Owner’s Compensation

A homebuilder’s owner paid himself a salary that was much higher than the CEO of any similar company would normally receive. It was his decision as to whether he wanted to receive the funds as salary or as a draw against earnings, but it did cause widespread resentment within the company, especially during lean times.

The important point here, though, is that by adding back the excess owner’s compensation into the cash flow projections, the company’s value increased by a multiple of say, 6 or 7 times that amount.

Below-Market Rents

A retailer had been in business for many years, and was such a desirable tenant that it could drive a very hard bargain with landlords. It was common to find 20 year leases at below-market rates, with 10-year extensions. A careful reading of the lease on the ideally-located head office revealed that it ran in perpetuity.

The low rents increased the company’s cash flow, and would have been taken into account if the company had been valued strictly on a multiple of that cash flow. Valuing leases uses much the same arithmetic as arriving at a multiple of earnings, but the terms of these leases were so unusual that we saw the need to evaluate them as a separate asset.

Ultimately, we prepared cash flow projections using much higher market-rate rents. This reduced the amount a buyer would pay for the company based on its projected cash flows, but it was more than made up by the higher value assigned to the leases as a separate asset.

Unusual Expenses

The owner of another company had a unique set of personal beliefs, and insisted that all of his employees and vendors share or participate in them – at considerable cost. Everyone was required to attend expensive week-long seminars by a California-based consultant who taught them how to deal with their personal fears. Another consultant was flown in from San Francisco for a week to realign the chakras of the executive staff. The owner catered lunches several times a week, so the entire staff would attend his meditation sessions. The company sponsored a project in which meditation experts gathered in Sedona to effect world peace.

It was highly unlikely that a buyer would continue these human resource policies, so we added back their cost to normalized cash flow, and substantially increased the asking price of the company.

Historic Land Values

A land developer and homebuilder had been in business for many years, and owned properties it had purchased up to 30 years previously. The profit margins on the houses it sold were significantly higher than they would have been if the land were acquired more recently.

There had been talk within the company of separating the land component of the business from the homebuilding component, in order to clearly see where the profit and returns on investment really came from, but the initiative never got off the ground.

The low historic land values were reflected in profits, but not in the actual operating cash flows, so a valuation based on a multiple of cash flow didn’t make sense. We prepared normalized cash flow projections for the homebuilding business based on market prices for the land, and did a separate valuation of the land reserves, based on those same market prices.

Non-Recurring Costs

Most companies have expenses they needed to incur a single time, or for a limited period. Examples I have seen include legal fees and settlement costs for lawsuits, discretionary bonuses for unusual personal or company performance and employee termination costs. I worked with a company that had incurred huge expenses trying to start a new line of business that was never realized. Another committed to a year-long sponsorship of a local sports team in a marketing effort that was judged a failure.

None of these costs can be expected to be repeated by a buyer of the company, and so should be added back to the normalized historic earnings, and to the cash flow projections used to place a value on the company.

Does your CFO understand the value of normalizing your cash flows from a buyer’s point of view?

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Hmmm… Didn’t Think of That

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There are executives who rely on their ability to move quickly. They are often the ones who loudly declare that if we sit around analyzing things to death, we’ll never get anything done. Sometimes, they’re also the ones who are willing to bet the farm before the analysis has been thoroughly completed.

I love working with these high-velocity types, but they often need someone like me watching their back. Someone with a strong business sense and analytical capability who doesn’t slow down the process.

Here are some examples of how things can go wrong:

Catalogue Stores

A well-known retailer operated discount department stores nation-wide. To reach a wider customer base, they also operated a successful chain of catalogue stores in communities too small to support a full-service store. A customer would place his order at a catalogue store, and the item would be delivered within a week.

Meanwhile, changes in technology and inventory management techniques had resulted in a substantial reduction of inventory carried in the full-service stores. These were large stores, so quite a lot of physical space was freed up.

A senior executive came up with the idea to put catalogue stores in the available space in the full-service stores. His analysis showed that not only would the new catalogue stores add substantial revenue and profit to the existing outlets, but they could easily be placed in the least desirable selling areas, often in store basements.

There was much fanfare as the project was launched. The executive in charge even ran afoul of his boss and colleagues when newspaper articles praised his brilliance beyond their comfort level. Then the catalogue stores were abruptly shut down as a disastrous failure. Why would a customer walk through the store, passing by the merchandise he wants to buy, only to order it in a dark basement for delivery a week later? Hmmm… didn’t think of that.

Paper Shortage

A young warehouse worker at a large office supplies distributor showed such ability and intelligence that he was rapidly promoted to be the company’s purchasing agent. This was a long time ago, in the mid-1970s, when the oil crisis resulted in chronic shortages of a surprising range of products.

One day, the purchasing agent called to place a routine order of reams of 8 ½ x 11 inch printer paper. “6 months’ delivery” he was told, and he realized he would be unable to fulfill his customer orders for much of that time.

He was a smart kid, so it didn’t take long to figure out that when the shipment did arrive, he could be looking at another 6 months for the next delivery. Of course he didn’t ask for advice. He started placing orders every couple of weeks, based on historical usage, fully expecting to be back on his regular schedule at the end of the 6 months. Yes, he was a smart kid.

The only problem is that it was a big company, and after a while, the orders accumulated into a quantity large enough to justify an entire separate mill-run by the manufacturer. There were delivery trucks at the door for days on end, and you had to walk sideways through the warehouse to get past the stacks of paper. Hmmm… didn’t think of that.

Demographics

A retailer launched a new business based largely on demographics. It was the early 1980s, and the Baby Boomers were just starting to have children of their own. It was the beginning of a huge increase in births that the industry was calling the Echo Boom. What better time to start a chain of stores specializing in children’s apparel?

After establishing a solid base in California, the plan was to follow the demographic projections that showed high percentage population growth in the southern states. The company made an aggressive move into Texas, and suffered from an economic downturn and some bad real estate decisions, resulting in the prompt closure of about half of the new stores. Still, the roll-out through the south remained the CEO’s plan.

This is the only example in this article in which I was able to play a part, so of course, I’m the hero of this story. I pointed out that the southern states were in fact projected to grow at high percentage rates, but the population density was insufficient to achieve the economies resulting from tight clustering of stores. After all, 10% of nothing is still nothing. Hmmm… didn’t think of that.

The management team listened to my presentation, and we headed instead to the northeast, where large populations were already in place. Our strategy shifted to taking business away from the department stores.

Does your CFO sit in on strategy meetings and tactical problem-solving sessions? He might just bring an important new perspective.