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.  

I, Pencil
My Family Tree as told to Leonard E. Read

I am a lead pencil—the ordinary wooden pencil familiar  to all boys and girls and adults who can read and write.*

Writing is both my vocation and my avocation; that’s all I do.

You may wonder why I should write a genealogy. Well, to begin with, my story is interesting. And, next, I am a mystery—more so than a tree or a sunset or even a flash of lightning. But, sadly, I am taken for granted by those who use me, as if I were a mere incident and without background. This supercilious attitude relegates me to the level of the commonplace. This is a species of the grievous error in which mankind cannot too long persist without peril. For, the wise G. K. Chesterton observed, “We are perishing for want of wonder, not for want of wonders.”

I, Pencil, simple though I appear to be, merit your wonder and awe, a claim I shall attempt to prove. In fact, if you can understand me—no, that’s too much to ask of anyone—if you can become aware of the miraculousness which I symbolize, you can help save the freedom mankind is so unhappily losing. I have a profound lesson to teach. And I can teach this lesson better than can an automobile or an airplane or a mechanical dishwasher because—well, because I am seemingly so simple.

Simple? Yet, not a single person on the face of this earth knows how to make me. This sounds fantastic, doesn’t it? Especially when it is realized that there are about one and one-half billion of my kind produced in the U.S.A. each year.

Pick me up and look me over. What do you see? Not much meets the eye—there’s some wood, lacquer, the printed labeling, graphite lead, a bit of metal, and an eraser.

Innumerable Antecedents

Just as you cannot trace your family tree back very far, so is it impossible for me to name and explain all my antecedents. But I would like to suggest enough of them to impress upon you the richness and complexity of my background.

My family tree begins with what in fact is a tree, a cedar of straight grain that grows in Northern California and Oregon. Now contemplate all the saws and trucks and rope and the countless other gear used in harvesting and carting the cedar logs to the railroad siding. Think of all the persons and the numberless skills that went into their fabrication: the mining of ore, the making of steel and its refinement into saws, axes, motors; the growing of hemp and bringing it through all the stages to heavy and strong rope; the logging camps with their beds and mess halls, the cookery and the raising of all the foods. Why, untold thousands of persons had a hand in every cup of coffee the loggers drink!

The logs are shipped to a mill in San Leandro, California. Can you imagine the individuals who make flat cars and rails and railroad engines and who construct and install the communication systems incidental thereto? These legions are among my antecedents.

Consider the millwork in San Leandro. The cedar logs are cut into small, pencil-length slats less than one-fourth of an inch in thickness. These are kiln dried and then tinted for the same reason women put rouge on their faces. People prefer that I look pretty, not a pallid white. The slats are waxed and kiln dried again. How many skills went into the making of the tint and the kilns, into supplying the heat, the light and power, the belts, motors, and all the other things a mill requires? Sweepers in the mill among my ancestors? Yes, and included are the men who poured the concrete for the dam of a Pacific Gas & Electric Company hydroplant which supplies the mill’s power!

Don’t overlook the ancestors present and distant who have a hand in transporting sixty carloads of slats across the nation.

Once in the pencil factory—$4,000,000 in machinery and building, all capital accumulated by thrifty and saving parents of mine—each slat is given eight grooves by a complex machine, after which another machine lays leads in every other slat, applies glue, and places another slat atop—a lead sandwich, so to speak. Seven brothers and I are mechanically carved from this “wood-clinched” sandwich.

My “lead” itself—it contains no lead at all—is complex. The graphite is mined in Ceylon. Consider these miners and those who make their many tools and the makers of the paper sacks in which the graphite is shipped and those who make the string that ties the sacks and those who put them aboard ships and those who make the ships. Even the lighthouse keepers along the way assisted in my birth—and the harbor pilots.

The graphite is mixed with clay from Mississippi in which ammonium hydroxide is used in the refining process. Then wetting agents are added such as sulfonated tallow—animal fats chemically reacted with sulfuric acid. After passing through numerous machines, the mixture finally appears as endless extrusions—as from a sausage grinder-cut to size, dried, and baked for several hours at 1,850 degrees Fahrenheit. To increase their strength and smoothness the leads are then treated with a hot mixture which includes candelilla wax from Mexico, paraffin wax, and hydrogenated natural fats.

My cedar receives six coats of lacquer. Do you know all the ingredients of lacquer? Who would think that the growers of castor beans and the refiners of castor oil are a part of it? They are. Why, even the processes by which the lacquer is made a beautiful yellow involve the skills of more persons than one can enumerate!

Observe the labeling. That’s a film formed by applying heat to carbon black mixed with resins. How do you make resins and what, pray, is carbon black?

My bit of metal—the ferrule—is brass. Think of all the persons who mine zinc and copper and those who have the skills to make shiny sheet brass from these products of nature. Those black rings on my ferrule are black nickel. What is black nickel and how is it applied? The complete story of why the center of my ferrule has no black nickel on it would take pages to explain.

Then there’s my crowning glory, inelegantly referred to in the trade as “the plug,” the part man uses to erase the errors he makes with me. An ingredient called “factice” is what does the erasing. It is a rubber-like product made by reacting rape-seed oil from the Dutch East Indies with sulfur chloride. Rubber, contrary to the common notion, is only for binding purposes. Then, too, there are numerous vulcanizing and accelerating agents. The pumice comes from Italy; and the pigment which gives “the plug” its color is cadmium sulfide.

No One Knows

Does anyone wish to challenge my earlier assertion that no single person on the face of this earth knows how to make me?

Actually, millions of human beings have had a hand in my creation, no one of whom even knows more than a very few of the others. Now, you may say that I go too far in relating the picker of a coffee berry in far off Brazil and food growers elsewhere to my creation; that this is an extreme position. I shall stand by my claim. There isn’t a single person in all these millions, including the president of the pencil company, who contributes more than a tiny, infinitesimal bit of know-how. From the standpoint of know-how the only difference between the miner of graphite in Ceylon and the logger in Oregon is in the type of know-how. Neither the miner nor the logger can be dispensed with, any more than can the chemist at the factory or the worker in the oil field—paraffin being a by-product of petroleum.

Here is an astounding fact: Neither the worker in the oil field nor the chemist nor the digger of graphite or clay nor any who mans or makes the ships or trains or trucks nor the one who runs the machine that does the knurling on my bit of metal nor the president of the company performs his singular task because he wants me. Each one wants me less, perhaps, than does a child in the first grade. Indeed, there are some among this vast multitude who never saw a pencil nor would they know how to use one. Their motivation is other than me. Perhaps it is something like this: Each of these millions sees that he can thus exchange his tiny know-how for the goods and services he needs or wants. I may or may not be among these items.

No Master Mind

There is a fact still more astounding: the absence of a master mind, of anyone dictating or forcibly directing these countless actions which bring me into being. No trace of such a person can be found. Instead, we find the Invisible Hand at work. This is the mystery to which I earlier referred.

It has been said that “only God can make a tree.” Why do we agree with this? Isn’t it because we realize that we ourselves could not make one? Indeed, can we even describe a tree? We cannot, except in superficial terms. We can say, for instance, that a certain molecular configuration manifests itself as a tree. But what mind is there among men that could even record, let alone direct, the constant changes in molecules that transpire in the life span of a tree? Such a feat is utterly unthinkable!

I, Pencil, am a complex combination of miracles: a tree, zinc, copper, graphite, and so on. But to these miracles which manifest themselves in Nature an even more extraordinary miracle has been added: the configuration of creative human energies—millions of tiny know-hows configurating naturally and spontaneously in response to human necessity and desire and in the absence of any human master-minding! Since only God can make a tree, I insist that only God could make me. Man can no more direct these millions of know-hows to bring me into being than he can put molecules together to create a tree.

The above is what I meant when writing, “If you can become aware of the miraculousness which I symbolize, you can help save the freedom mankind is so unhappily losing.” For, if one is aware that these know-hows will naturally, yes, automatically, arrange themselves into creative and productive patterns in response to human necessity and demand—that is, in the absence of governmental or any other coercive masterminding—then one will possess an absolutely essential ingredient for freedom: a faith in free people. Freedom is impossible without this faith.

Once government has had a monopoly of a creative activity such, for instance, as the delivery of the mails, most individuals will believe that the mails could not be efficiently delivered by men acting freely. And here is the reason: Each one acknowledges that he himself doesn’t know how to do all the things incident to mail delivery. He also recognizes that no other individual could do it. These assumptions are correct. No individual possesses enough know-how to perform a nation’s mail delivery any more than any individual possesses enough know-how to make a pencil. Now, in the absence of faith in free people—in the unawareness that millions of tiny know-hows would naturally and miraculously form and cooperate to satisfy this necessity—the individual cannot help but reach the erroneous conclusion that mail can be delivered only by governmental “master-minding.”

Testimony Galore

If I, Pencil, were the only item that could offer testimony on what men and women can accomplish when free to try, then those with little faith would have a fair case. However, there is testimony galore; it’s all about us and on every hand. Mail delivery is exceedingly simple when compared, for instance, to the making of an automobile or a calculating machine or a grain combine or a milling machine or to tens of thousands of other things. Delivery? Why, in this area where men have been left free to try, they deliver the human voice around the world in less than one second; they deliver an event visually and in motion to any person’s home when it is happening; they deliver 150 passengers from Seattle to Baltimore in less than four hours; they deliver gas from Texas to one’s range or furnace in New York at unbelievably low rates and without subsidy; they deliver each four pounds of oil from the Persian Gulf to our Eastern Seaboard—halfway around the world—for less money than the government charges for delivering a one-ounce letter across the street!

The lesson I have to teach is this: Leave all creative energies uninhibited. Merely organize society to act in harmony with this lesson. Let society’s legal apparatus remove all obstacles the best it can. Permit these creative know-hows freely to flow. Have faith that free men and women will respond to the Invisible Hand. This faith will be confirmed. I, Pencil, seemingly simple though I am, offer the miracle of my creation as testimony that this is a practical faith, as practical as the sun, the rain, a cedar tree, the good earth.

* My official name is “Mongol 482.” My many ingredients are assembled, fabricated, and finished by Eberhard Faber Pencil Company.

Leonard E. Read (1898-1983) founded FEE in 1946 and served as its president until his death.

“I, Pencil,” his most famous essay, was first published in the December 1958 issue of The Freeman.

I recognize that there are a lot of business owners who are used to boot strapping and think:  "I've been able to figure out how to be successful in business, I'm sure I can figure out how to sell my own business.  Why hire a business broker or investment banker to help?  How hard can it be?"

In the following article published by Axial Market, they describe a study in which 4,468 acquisitions of private sellers between 1980 and 2012 were examined.  The conclusion was that private sellers receive significantly higher acquisition premiums when they retain M&A advisors.  See:  M&A Advisors Proven to Improve Valuations

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.  

Do you remember Buckminster Fuller, the architect, systems theorist, inventor, and futurist who passed away in the early 1980s?  He felt that most social problems would not be remedied by politicians or philanthropists but rather by technological advances.  He was into sustainability and minimalism before it was popular.  He coined the term "ephemeralization" to describe his primary thesis of the ability of technological advancement to do more and more with fewer and fewer resources until eventually you can do nearly everything at a very low cost and using the least amount of resources possible. This sounds a bit like the Reduce, Reuse, and Recycle mantra of many of today's sustainability promoters.
  
His belief was that ephemeralization would result in ever-increasing standards of living for an ever-growing population despite finite resources.  One of the ways that he believed this would occur is through disruptive innovation - where new ways of thinking, and new technologies would create novel and better solutions to life's problems.  

Here’s a quote I came across today from Bucky:

“In order to change an existing paradigm you do not struggle to try and change the problematic model. You create a new model and make the old one obsolete.”

I'm a fan of Bucky's thought process.  It's amazing to look at the last 50 years of innovation and consider how much more efficiently we can do so many things today.   

While there are several things that Codiligent has already done to change the traditional problematic business brokerage model, Bucky's ideas challenge me to consider what else can I do to create an entirely new and better model for buying and selling businesses?  If you have ideas I'd love to hear them.

Likewise, I challenge you to think about what can you do in your industry that is revolutionary, not evolutionary?  What paradigm can be shredded, discarded, and replaced by a new more efficient and effective model for your industry?

A common misconception of business sellers is that if a business has a low price because there is a corresponding low level of Seller Discretionary Earnings (Earnings Before Interest Taxes Depreciation and Amortization plus the expensed wages of one owner) it will be easier to sell given that more buyers can come up with a few hundred thousand dollars, than millions of dollars.

Unfortunately, there are other factors that tend to outweigh this logic.  Most individuals who are sophisticated enough to be serious about acquiring a business, and who have the financial wherewithal to do a deal, are also able to earn high salaries working for someone else.  Most of the acquirers that Codiligent has worked with would be able to command salaries of $100,000+ a year working for someone else (often far higher).  So, the challenge is that if someone is able to earn $100,000+ a year working for someone else without the expense and risk of business ownership, it is hard to justify paying for a business in which they will earn a similar amount of money.  For example, if an acquirer could make $100,000 working for someone else, but was looking at a business valued at $300,000 which was generating $110,000 of Seller Discretionary Earnings, their remaining cash flow beyond a market rate of compensation for their labor would be just $10,000. This would represent a meager 3% annual return on their $300,000 investment.  

With companies that are looking to buy another business as a strategic acquisition, the challenge is often that after paying someone to run the business there will be too little cash flow remaining to justify devoting the time, attention, and resources to the acquisition unless they have a way to significantly increase cash flow, and even then it still may make more sense for them to leverage their time, energy, and resources on a larger alternate transaction.

There are reasons a buyer may still be interested in a smaller acquisition, for example: an individual may buy a company for lifestyle, opportunities for growth, because they are passionate about the type of business, or they desire to live in the location of the business.  Perhaps a strategic buyer may be able to cross sell the target company's products or services, may gain a new technology or R&D, or might gain client relationships or some other advantage. However as a general rule, businesses with more than $150,000 in re-cast Seller Discretionary Earnings will be more marketable than those with lower Seller Discretionary Earnings.

Economist Milton Friedman provides a compelling rationale for the benefits of free enterprise directing resources versus political control over the means of production in this fun exchange with a very youthful Phil Donahue.

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.