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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Profit Improvement – Allocation of Resources

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Pretty much every company wants to increase its profit, and most managers devote a large portion of their time to trying to increase revenues and margins, or reduce costs. As a financial manager and consultant, I have been involved in many profit improvement initiatives. Here are some examples – they are mostly from construction, retail and land development, but the concepts can be applied to any business.

Allocation of Resources

Where a company chooses to invest its resources has an important effect on its profitability and ROI. This can be managed at the time of the initial investment, but ongoing investment needs to be reviewed with a critical eye.

Profit maximization – A land developer and builder was very disciplined in its due diligence on land acquisitions. Land development is a surprisingly complex process involving massive investment, and is subject to a seemingly endless list of restrictions and costly requirements from all levels of government. So choosing between land investment opportunities is a painstaking process, but often subject to emotional responses. We built a linear programming model to maximize the profitability of our land use plans based on our budgets and timing, as well as the attendant marketing and government constraints. This removed much of the emotion from the land acquisition process.

Unprofitable operations – A homebuilder was focused on entry-level housing, and suffered from tight margins and the need for economies of scale and tight discipline in that sector of the business. At the same time, its land entitlement and development business was generating high margins and even higher returns on investment. With 80% of the company’s overhead, but only a small percentage of profits coming from homebuilding, we weighed the investment required to operate a full-scale builder in a higher price category against the potential return, and decided to walk away from the business entirely. Overhead was drastically reduced, and capital was redirected to the more profitable business of land development.

More profit with lower investment – A retailer was famous for the department stores it had operated for many years. Over time, though, these stores had lost ground to competitors, and capital investment had been cut back in proportion to declining profits. The company also operated a number of successful specialty store formats. A time of reckoning came, and the company realized it could make management changes and invest heavily in its department stores, possibly reaching the level of success, for example, of Target Stores. After an intense review, though, they recognized that specialty stores had a higher potential return, a relatively lower investment, lower risk and correspondingly low barriers to entry in niche specialty markets. Relying on its depth of experience, the company closed its famous department stores, and reallocated its funds and energies toward rapid growth in specialty retailing. It became one of the top-performing companies on the New York Stock Exchange.

Drawing on strengths – Another homebuilder operated in a single market, selling low margin homes during a downturn in the housing market. Recognizing its strength in efficient, low cost construction, it started looking for new opportunities. We focused on selling houses at full margin for rental by investment partnerships, expanding regionally into new markets through joint ventures, construction for hire of military housing and multifamily construction.

Does your CFO lead your management team in constant evaluation of your resource allocation process?

Valuing a Consulting Business

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There are probably hundreds of reasons why you might contemplate selling your consulting business. Among them would be retirement, changing markets, illness or just the urge to move on and do something new.

Who is the buyer?

The buyer will probably be another consultant – either a competitor or a firm with a desire to expand their offering to include your area of expertise. It is unlikely that there will be financiers, or others with no direct experience standing in line to buy your business. There is, however, a pretty good chance the buyer will be a partner or an employee, in which case you need to start talking to financial planners long before you expect to do the transaction.

What are they buying?

When you think of selling the business, you tend to think of it as just that… the business. When we start thinking about its value, though, it is a good idea to put ourselves in the buyer’s position. What specifically does the buyer hope to acquire?

–          Your client list / existing relationships.

–          Expertise in a new field, or the opportunity to serve a backlog of client demand.

–          Name and reputation.

–          An instant start in the business with a functioning team – it saves the time, energy and uncertainty of building the business from scratch… as long as the cost isn’t too high.

–          Ability to leverage your client base – the buyer can provide services from your business to his existing clients, or alternatively, sell new services to your current clients.

–          Owner to stay on through a transition period – to facilitate the smooth transfer of relationships, retention of staff, transfer of knowledge and expertise.

What is the price?

Consulting firms typically have relatively little in the way of assets, so one way or another, the selling price is likely to be a multiple of earnings or cash flow. EBITDA (earnings before interest, depreciation and amortization) is a traditional measurement of cash flow, but why not add back your salary and any special items such as health care and travel that could be considered personal, and would not be costs to the company after the sale? Also consider accounting, legal, insurance etc. costs that will go away after the acquisition.

The value of a single-person operation will probably be lower because of the impracticality of having the seller stay on through a transition period, and the higher risk of losing clients.

The purchase price will depend on the exact fit with the buyer’s business, and the time and cost of entering the field. Remember that if you ask too high a price, the buyer may decide to start the business from scratch, maybe even hiring your best employees away from you, and competing for your existing clients.

Rules of thumb – selling prices generally fall between 2.5 and 3.5 times earnings (high utilization rates and low costs will result in a higher value) OR .75 to 1.25 times gross revenue, which probably yields the same value, depending on your profit margins.

The purchase price will be higher if you stay on through a transition period. You would draw a salary, of course, and it doesn’t hurt to be there to keep an eye on your payout.

Payment Structure

You’ll get the highest price if it is paid out over time, say 2 – 3 years. An up-front payment in the range of 25% is common.

Remember that if a buyer pays 3 times earnings up front, he will get no return on his investment for 3 years, a situation that few investors can tolerate. Even if there are synergies that result in additional business, the buyer would probably have to lay out additional investment to realize them.

 

Do you know who to call if you need help selling your business?

 

What? … Manage Return on Equity?

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Return on Equity, or ROE, is a widely recognized measure of a company’s performance. Even though some senior executives’ compensation is based on ROE or a similar measure, many regard it as an academic, technical calculation, and wait until year-end for the accountants to give them the result.

ROE tells you how effectively you are using your company’s resources, and it CAN be managed. It is a tool that should be evaluated and refined constantly to ensure your business is headed in the right direction. It can be managed by breaking it down into its separate components:

The calculation of ROE is:

ROE = Profit Margin X Asset Turnover X Financial Leverage

Profit margin is your profit as a percentage of sales. No surprises here. You know your industry, and you know your company, and you know how to improve your margins.

Asset turnover is your sales divided by your total assets. Turnover drops when you carry more standing inventory than you need, or make capital investments before you really need them. Faster collection of accounts receivable will improve your asset turnover… And obviously, increasing sales will improve your turnover.

Financial leverage is your total assets divided by shareholders’ equity. Negotiating longer vendor payment terms can increase financial leverage. So can increasing debt, but that is a complex decision that should be discussed in depth with your CFO.

Does your CFO work with you and your operating teams to improve the components of ROE?