The following video from the Kauffman Foundation exposes some myths about entrepreneurship but they excluded one of the most significant myths: 7 out of 10 businesses fail in the first five years. This tired old misperception stems from confusion about the difference in the definitions of "non-survival" and "failure". Non-survival isn't the same as failure. Many businesses that don't survive are far from being failures. Contact Codiligent business brokers if you'd like to learn the truth about business failure rates (which are significantly lower than commonly perceived).
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:
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:
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
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:
What's an appropriate amount for a retention bonus? Here are some of the factors to consider:
Ever wonder how small business owners collectively view political issues? You might be interested in reading the National Small Business Association's report "The Politics of Small Business". If you know many small business owners then many of the results may not surprise you. For example, small business owners are independent, critical thinkers with only less than 18% voting a straight party ticket.
Some of the other results include:
How would you like to see city, state, and local government help small businesses?
Many business owners underestimate the nuances and complexity of exit planning. Unfortunately, this is often exacerbated by some professional advisors who strive to overly control the process or who want to be the sole representative of the business owner in assisting with the process. For example, a contract CFO, wealth manager, CPA, or attorney may be keenly interested in exit and transition planning and may have significant experience, formal education, attended seminars, and read books on the subject. However, I would argue that it would be the rare individual who will have expertise and skill in all areas necessary to help a business owner optimize their exit.
Rather, a business owner should be looking for advisors who play well with others. So, yes, an attorney plays a vital role in the exit process, but they aren't an accountant and may not possess some of the knowledge of a CPA. Likewise, while the attorney may be good at helping protect clients through appropriate legal documents, and the CPA may have invaluable advice on the tax implications of the deal structure, neither of these professionals may have the skill set that an investment banker or business broker has of analyzing, valuing, and packaging the business or of finding and screening the best buyer and negotiating a win-win deal. And what about planning for what a business owner will do after the sale? Is a business broker, investment banker, attorney, or CPA going to be the best person to provide advice on what type of assets you need to own to securely provide for your long-term financial needs and reach goals in the next chapter of your life? Or might a wealth manager be better equipped to provide this type of guidance?
Following is a link to an article published by Axial Market that provides some ideas on the value of a good Exit Team: How Deal Teams Increase the Odds of a Favorable Exit.
How important is economic freedom? Are less free and more regulated people, as a whole, just as well off as those with more economic freedom? Are all types of economic organization equally good but with different pros and cons? Or does economic freedom truly lead to a higher quality life? Which countries' people have the lowest quality of life and what is their level of economic freedom? Do property rights really matter? Is a smaller or larger role for government better?
Check out the following 60-second video that provides a perspective on this topic. What do you think?
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:
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.
Buy and Sell Well
Codiligent Business Brokers' blog on entrepreneurship, capitalism, and successfully buying and selling businesses.
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