You may have heard people talk about "quality of earnings" when valuing a company or deciding whether to make an acquisition. What does this mean? Generally it refers to how consistent a company's earnings are with its cash flow, so that things like accounting practices, the way inventory is accounted for, working capital requirement, and accruals aren't overly distorting those earnings. However, in practice, many business buyers also use this term to describe the degree to which they can rely upon and predict earnings - and this can be impacted by factors such as: whether financial statements are compiled, reviewed, or audited by a CPA; whether client revenue is recurring, repeat, or one-time; and whether there is a stable cost structure (i.e. the degree to which inventory prices fluctuate; is there a long-term lease in place that provides a predictable rent expense; are employees at market rates of compensation so that when there is turnover payroll expenses will stay the same; etc.).

How do quality of earnings relate to value? I'd first point out that valuing a business is a surprisingly complex and nuanced process, and theoretical value can't be allowed to overshadow common sense. For example, a business that is generating Earnings Before Interest Taxes Deprecation and Amortization (EBITDA) of $200,000 may be worth $1 million if using an income-based approach to value, but if such a business has assets that could be auctioned for $1.2 million and has no debt, then, of course, it would be worth more than $1 million as long as there is a market for its assets. Nevertheless, for the majority of financially well-performing businesses, value will be impacted by three primary factors:

1. The level and quality of earnings;
2. Risk factors; and
3. Growth prospects

A business with a higher level and/or higher quality of earnings is going to be worth more than a business that has a lower level and quality of earnings, assuming similar risk factors and growth prospects.

Following is a link to an article that describes some of the things that buyers look at during due diligence to determine the quality of earnings:  Quality of Earnings: A Critical Component of Due Diligence

A while back when I was getting ready to close a business sale transaction a client was confused by why he would owe a commission on inventory that was being acquired by the buyer.  The listing agreement clearly states that a commission will be owed on all assets acquired by a buyer. However, I understand what caused the confusion.

When I help clients negotiate a Letter of Intent (LOI), often we will show a base price of the business plus the inventory at wholesale cost, with the combination of the two being the total price of the business.  The inventory is an asset of the business that's necessary for its operation.  Buyers expect that a business will come with inventory consistent with what's been carried in the past so that there is continuity of the business when the transaction closes.  

The only reason that we delineate the inventory in the LOI and Purchase Agreement is to prevent perceptions of game playing and disagreements between a Buyer and Seller about inventory levels at closing.  In other words, had we said that the price was $1,750,000 for the business (without breaking out the inventory, which at time of LOI was $500k) then when closing rolled around if the actual inventory ended up being $600k, a seller would be inclined to say "wait a second - when we signed the LOI the inventory level was only $500k, now it's $600k, Mr. Buyer you need to pay me an extra $100k for the business - I'm not going to sell for $1.75 million."  In contrast, if at closing inventory was only $400k a buyer would be inclined to say, "Mr. Seller, I wonder if you've intentionally depleted your inventory.  You should have been replacing the inventory you consumed to keep it consistent with the levels that were present when we signed the LOI.  We need to amend our agreement to decrease the price by $100k."  However, by saying the price is $1.25 million plus inventory it results in a total price that naturally adjusts.

Of course, there are other ways this could also be addressed in the language of the documents, for example, saying that $500k of inventory would be included and that if it was more or less at time of closing the overall price would simply adjust. Regardless of how it is addressed, most buyers expect to acquire inventory needed to operate the business and will want the overall closing price to be adjusted to reflect any changes in the level of inventory that occurred from the time the LOI was signed until closing.

Some sellers may say, "OK - but if we are showing inventory as an additional deal component but only at our cost - that shouldn't be subject to the commission we didn't make a profit on it."  However, the base price of the transaction is where the intangible business value is captured, and a buyer will need sufficient inventory to operate the business.  If a seller said, I'm just going to sell the inventory on my own and the buyer can acquire their own inventory there would be a number of issues:

• The seller would still need to find someone to buy their inventory at closing and a third party willing to buy it  would likely pay a discount for the inventory compared to if buying it directly from a  supplier. There also may be advertising or selling costs to locate a buyer and negotiate a sale of the inventory.
• A seller will have a difficult time managing their inventory down to a minimal level to coincide with the business sale transaction closing.
• Many businesses have a variety of types of inventory and some of it must be bought in minimum quantities - so requiring a buyer to obtain these minimum quantities directly from suppliers may be less economical than the buyer simply buying a seller's inventory.
• A buyer will need to have all inventory on hand at closing to avoid an interruption of service to clients, and if they wait until closing to buy their own inventory there may be a gap in service and corresponding decline in the business.
• Buyers expect that they will be acquiring sufficient levels of inventory to maintain the operation of the business.  Consequently, they will be annoyed if they have to jump through hoops at or before closing to take care of stocking raw goods inventory.
• Depending on the type of business there might be a long lead time in the manufacturing process to take inventory from raw goods inventory to a finished product.  If that is the case and there aren't work-in-process or finished goods inventory included with the assets a business buyer will have a delay between the acquisition of the business and creating the finished goods inventory that can be sold to customers.

About the only time that inventory may not be included in a sale, or where a commission might be negotiable (which should be negotiated at time the listing agreement is signed) is if there is significant excess but marketable  inventory beyond what is required for the normal operation of the business.  

It's fun to own a business when times are good. You're selling in-demand products and services, gaining appreciative clients, creating new jobs, growing revenue, the bank is patting you on the back, you're receiving awards and accolades, the economy is growing, and you are making more money than you ever dreamed  possible. That makes it a perfect time to sell!

Many business owners make the mistake of putting off selling for a few more years. Perhaps you know you want to exit within about five years but think "with things going so well, I'll wait a little longer before attempting to sell." But what if something unexpected happens? What if you lose two of your key clients? You lose a key staff member? A group of former disgruntled employees sues the company? A key supplier dramatically increases prices? The economy goes into recession? New regulations are imposed that are incompatible with your business model? Such changes could make your business entirely unmarketable in the short-term, negatively impact value, and may require waiting far longer to sell in order to correct the problems and develop enough of a track record afterwards that it won't have a significant impact on business value and marketability. Your plan of selling within 5 years? That may now be 10 years.

However, there's another reason that waiting to sell may not be such a good idea: we're in a seller's market, but it's not likely going to last. There are estimates of $1-2 Trillion of investment capital (between private equity groups and corporations) currently sitting on the sidelines looking to be placed in acquisitions. Given the low yield on US Treasuries (which set the minimum benchmark return as a very safe investment) the correlated return expected on equity investments is also low, and the cost of acquisition debt capital is low. The result of the massive amounts of investment capital and low interest rate environment has been higher prices being paid to sellers of successful businesses. Who knows how long it will be before interest rates start increasing, but there's certainly not much room for them to go any lower. 

Right now the US Census Bureau indicates that over 70% of businesses that employ at least one person are owned by people over 53 years of age. Do you think some of those baby boomers are going to want to retire in the not too distant future?  What's going to happen if you wait to sell when the bulk of other small and medium size business owners also decide to sell? I think you know where I'm going with this: it is likely that within a few short year the "seller's market" is going to become a "buyer's market", which will likely result in lower valuations and may even render some businesses unmarketable. Perhaps a business owner who today could sell for 7x earnings will only be able to achieve a price of 4-5x earnings in the buyer's market. 

Following is a link to an article that describes the upcoming demographic shift in the business sale market: There's a Perfect Storm Approaching for Exiting Business Owners

Occasionally, I talk with a business owner who struggles to clearly and simply state what their business does, its unique value proposition, and the concrete benefits of its products or services.  This brings to mind an Albert Einstein's quote: "If you can't explain it to a six year old, you don't understand it yourself.”

While some people may think, "that's ridiculous - of course a business owner understands their own products or services - if they didn't how would they succeed in business?"  Yet, I find that some of the business owners I talk with may have a strong understanding of the features of their products or services, but may struggle to simply and clearly articulate the benefits that a customer derives - and perhaps if they did a better job of this their business may have been even more successful.  

Your business broker or investment banker will need a clear understanding of your product and service offerings, and why they are relevant to customers.  If you can't explain this to your business broker in a way that a six-year old can understand, there's a lower probability that your business broker will clearly understand it and be able to communicate it to buyers.  

If you returned from a one-month vacation would you come back to a business that would be operating as well as before you left?  Businesses that are the most valuable and the most marketable are those that don’t require daily management from an owner.  If through systemization, automation, documented processes, procedures, cross-training, and delegation the business can maintain good performance for a month in your absence, it will be a more compelling acquisition target.  If you are confident your business will perform well in your absence and you are getting ready to sell the business in the near future, you may want to consider taking a 3-4 week documented vacation.  If your company is able to demonstrate good performance during your time away, it will give an acquirer greater confidence of continued solid performance post acquisition, and that, in turn, may lead to a higher price and better terms.  So, go ahead: you have permission to take a long vacation.

One of the biggest risk factors for a business buyer is turnover of key employees in the company after the business is acquired.  One of the biggest risk factors for a business seller is that around the time he wants to sell a key employee will leave the company, which may not only cause a decline in performance of the company but may also increase buyers'  perceptions of risk.  The greater the risk that a business buyer perceives when contemplating an acquisition, the less likely they are to complete the deal and pay a premium price.  

Is there really much that can be done about this?  After all, you can't force key employees to continue working for the company.  You can, however, create attractive incentives for key employees to stay.  If you structure it the right way it may help you sell your business, and possibly get a higher price.   

How to do so?  Create a bonus for key employees who remain employed after the business is sold.  Codiligent business brokers are not experts at compensation or bonus programs.  However, we would encourage you to discuss the following ideas with professionals who have deep knowledge of employee compensation plans:

• Ideally you don't want a key employee to only stay up until the date that you sell, but rather it will usually be in both your and the buyer's best interest to encourage them to stay on long after the sale.  Consequently, consider paying at least part of the bonus one or two years after the business sale transaction closes.

• One of the challenges with setting up a bonus program as a way of encouraging retention through the sale process and post closing is that if it is promised to key employees too early, it may need to be larger in order to be compelling (i.e. a $50,000 bonus that will likely occur in two years, is quite a bit different than the same dollar amount being earned after seven years).

• You may want to use the bonus to help incentivize key employees to help you increase the value in the business while also putting golden handcuffs on them.  How?  Have the business professionally valued now.  Then have the bonus be at least partially based on an increase in the value of the company.  When you sell the business use the same business appraiser and have them use the same methodology previously used to value the company, and then use the increase in value as part of the pre-agreed-upon bonus formula.  Why not use the actual purchase price compared to the prior value estimate, since the actual price could be higher or lower?  Because using a consistent methodology makes it fair for the employee (i.e. what if the employee objectively helps increase the value of the business but you agree to a lower price with a business buyer; or how does the employee know that the starting value is accurate, maybe the starting value should have been lower which would have resulted in a larger gain.).  By having the bonus tied to an increase in a valuation methodology it closely aligns the key employee’s interests to the seller’s interests.  Codiligent offers a program called Always Ready To Sell in which the business is valued and fully packaged, and the value and packages are updated monthly so that a business owner is always prepared to sell.  Given that a consistent valuation methodology is used in this program every month, participating business owners could use it as the basis for calculating the bonus.

• The problem with having the retention bonus tied only to an increase in business value is what if, despite the key employee's best efforts and high level of skill, the business value doesn't increase?  This could be due to things like a decline in the general economy, a new competitive threat, or the loss of a few key clients that the key employee couldn't influence.  Yet, perhaps performance of the business would be even worse if the key employee was not employed by the business.  In such a situation it may be even more critical to retain the key employee.  So a business owner may want to consider a bonus that has two components:  a fixed base bonus amount plus a share of the increase in the value of the business.  

• Consider having the increase-in-value portion of the bonus be based on performance at the time of sale of the business (and not beyond), but deferring payment of the bonus (or a large part of it) until one year post sale and dependent on the continued employment by the acquirer.  This may make the employee nervous because they can’t control whether a new owner retains them - so you could agree to pay the bonus out earlier if the buyer terminates the employee.  However, that creates some moral hazard - because if the key staff member wants to leave they could participate in activities that would encourage termination.  Another way that may be better for handling this is to give 50% of the bonus to the employee at the time the business sale closes, and the remaining 50% if they continue to be employed by the company a year later.  

• By setting up such a bonus program at least a couple of years before an anticipated sale, it not only increases the likelihood of retention of the key staff member which may help protect value, but it can also allow you to be less secretive with key employees about a sale.  Most often I recommend that owners keep business sale intentions confidential from key staff members, but if there is a strong bonus a key employee who learns of a potential sale may be more excited about a big upcoming pay-day, than becoming nervous about the transition and looking at other employment opportunities.  By aligning your interest with your key employees' financial interests you may be able to let them in on your secret of selling, and they can be a useful and active ally in helping you sell the business. However, keep in mind that if the bonus is going to be a more modest amount, you may still want to keep the sale process confidential from key employees.  

• Most business buyers will be concerned about retaining key employees beyond one year.  During the sale process you can invite the buyer to offer the key employee an additional bonus after two or three years of service.

What's an appropriate amount for a retention bonus? Here are some of the factors to consider:

• How important is the key employee to the business.
• How difficult would it be to find a replacement staff member.
• Whether the company has key client, vendor, or strategic partner relationships where the key employee is the primary contact and the departure of said employee could result in termination or damage to the company’s continued relationship these stake holders.
• The redundancy of functional skill sets and degree of cross training within the organization.
• Whether knowledge the key employee possess is codified in systems or whether when they depart the company loses what was in their head.
• Whether there is an enforceable non-compete / non-solicit in place and/or if there isn’t then the degree to which the employee going to work for a competitor would harm the company.
• Reputation of the key employee in the industry.
• The market rate of compensation for their position.

Is your business designed to be sold? Let's look at two nearly identical businesses. Each is selling the same product or service into the same market. Each business is grossing $5 million in sales and netting $500,000 in profit. Each pays the same salary and benefits to its owner.

The owner of Company A works 70 hours per week, works most weekends, and has never taken a vacation longer than a week. The owner of Company B works 20 hours per week at his company, is a leader of his professional trade organization, and volunteers in multiple community organizations. He is regularly off visiting his grown children and grandchildren in other cities around the country, spends a month every winter in the tropics, six weeks every summer at a cabin in the mountains, and plays golf or skis at least one day a week when he is in town.

Which business  would you pay more to own? Which is most like your business and your life?

Chances are that Company A is so dependent on the owner's presence in the business to close sales, solve problems and make every-day decisions that most buyers will have great difficulty replicating the performance of the business once the owner has sailed off into the sunset.

Company B, on the other hand, likely has systems that control most day-to-day activities, long-term employees who are incented to support the vision that the owner developed for the business, and are empowered to make decisions for the business and take actions that are aligned with that vision. The owner simply provides guidance and monitors development of the business and his employees according to the plan, and works with his key staff to evolve that plan as business conditions change.

And business sale price and sale potential is not the only issue here. What would happen to each company if the owner suddenly died or became incapacitated?  Not only may Company A be more difficult to sell at a good price, the entire company is at risk of quickly failing. Without the expertise of the owner, that business is probably unsellable.

If your business and the time you spend in it is more like that of Company A than that of Company B, then the time to develop and begin implementing a plan for change is now. One of the best ways to make that happen is to work  with an experienced coach who can guide you through the planning and implementation  process and connect you to an advisory group consisting of other owners and CEO's who meet in a peer coaching framework.  As peers, other CEOs can offer you a "been there.... done that" perspective. There is a level of trust and belonging  with these CEO peer groups such as TAB (The Alternative Board) that is difficult to gain in other ways.

Following is a short video that illustrates the value of a peer group.

Account receivables aged greater than 30 days present a red flag for business buyers.  Cash flow is the life blood of a business and having a longer receivable collection period can starve a business of cash.  

Beyond the concern about cash flow, a slow collection of receivables can be an indication of problems such as:  

1. Customers delaying payment because of dissatisfaction with the product or service;
2. Claims or warranty issues that are causing customers to not pay in a timely manner; 
3. A company credit policy that encourages slow payments (i.e. no penalties for slow payments); 
4. Customers are experiencing financial difficulties that prevent them from paying, which may result in non-payment or even the loss of such clients should they become insolvent; 
5. Aged receivables might be uncollectible and an indication that the business has already lost the client; or
6. It may be an indication that the business simply has clients that willfully choose to delay payments through no fault of your company, which may mean that they are clients a buyer may not want to do business with.

If preparing for a business sale, all efforts should be made to collect aged receivables, write off those that are uncollectible, review and change credit policies to encourage more timely payment, and make it a priority going forward to collect payments within 30 days.

I'd like to thank Rebecca Conner at Merriman, a wealth management firm based in Seattle for sending me a link to a white paper published by Credit Suisse titled, "Life After an Exit:  How Entrepreneurs Transition to the Next Stage".  If you are considering selling your business at some point in time, it's a worthwhile read.  The focus is summarized in a quote from the article, "The challenge for an entrepreneur upon the sale of a company is twofold: how does one find new purpose, community, and structure for time; and how does one master wealth management and its new challenges and responsibilities?"

The white paper helps address not just the complex, and often surprisingly emotional issues related to selling, but also some of the practical and financial issues post sale.  The article has several case studies that go beyond the mechanics of exit planning and delve more into how other entrepreneurs found purpose after selling, what emotional issues they went through post-exit, how they developed meaning in life through relationships and other activities, and the issues surrounding developing and evolving a personalized strategy for comfortably managing wealth.  This is one of the most relevant and holistic white papers I've read about exit planning.