When a business is launched the hope is that the chosen market segment is a blue ocean and the opportunities vast. In the beginning the choices as to how to grow are wide open, so the decisions made today will influence the final stage in the life cycle of a business: The exit.
The exit strategy for the vast majority of privately held business owners is to sell the business to a third party. This usually delivers the highest return on investment for all of the capital, expertise, and time invested in building the business. As a business owner heads towards this final phase the big question is:
- Has the owner created a business with transferable value that a buyer can capitalize on, meet their ROI expectations, and therefore, is willing to pay a lofty price?
Simply put, transferable value is the worth of your business to a buyer without you in it and is the cornerstone of an exit plan. So as you can see, the price a business owner receives is dependent upon all the decisions made as they grew the business.
Most privately held business owners tend to believe that value is solely about profit. They focus upon increasing sales, margin growth, and cutting expenses. I often hear the 5x5x5 rule from owners. They believe that if they increase sales 5X, increase margins 5X and lower sales, general, and administrative (SGA) expenses 5X they have increased value. It’s not that easy.
Simply growing sales is not the solution.
I had a client with 63 MM in revenue, 14 MM EBITDA and no debt on the books. They were analyzing the impact of taking on a new customer that would add 10 MM in sales. Will that additional sales volume increase the business marketability in the eyes of the buyer? As it turned out, no. Projections showed the increased sales would stress the operational capacity requiring a capital infusion to expand operations resulting in adding debt onto the balance sheet. In addition, there was no evidence of economies of scale — costs were not going to decrease with more units sold, so margins would not increase. The financial model showed no increase in transferable value.
I have spoken with many business owners who believed that if they only grew their sales they would be in a better position when it came time to sell. Unfortunately, they quickly discovered that in reality they ended up needing to expand their operation in order to increase production capacity and add more employees. Ultimately, the demands placed upon them went through the roof with no increase to the bottom line. Just more headaches.
Increasing sales alone will not build transferable value. It is critical to also focus on many qualitative factors that drive profitability, growth, and the strength of an organization, resulting in a higher selling price.
Here are six steps that will increase transferable value and make the characteristics of your business more attractive to buyers:
Business Architect:
When a buyer is considering buying a business, scalability (the business can be expanded easily without a major capital outlay) is vital. Buyers want assurance that an increase in revenue will result in a corresponding increase in profit margin. This is not always possible! For example, when I worked as a CPA for PricewaterhouseCoopers an increase in revenue did not result in an increase in profit margin as the cost (time) increases equally. A product-based business can be easier to scale. I’m working with a software company right now and it is easily replicable—the software is developed so as the revenue grows from additional sales there will be incremental expenses, but no more development expenses and the profit margin soars.
A buyer will also evaluate the market share potential for future growth and whether your business can easily accommodate the growth. Years ago when Oprah featured products on her show the failure rate of the highlighted businesses was enormous because the operation was not capable of fulfilling the increased demand. The good fortune of being on Oprah was negatively dubbed the “Oprah Effect.”
Step 1: Evaluate your business and the potential to scale. Be mindful of market demand. Note that you may not have replicated your business because of lack of capital or knowledge, but if you can prove it is possible to scale your business and that there is market demand, your business will be much more attractive in a buyer’s eyes. And don’t make the mistake of holding onto a business too long. The ideal time to sell is way before the business peaks. Remember a buyer is investing in future growth potential so sell when it is on its way up.
Management Team:
Having a well-developed management team assures an investor that the business is not owner dependent and that if you are no longer part of the equation the business will continue to expand. Human capital is one of the most valuable intangible assets. If your exit strategy is to transfer ownership to a third party via a sale; the quality and depth of your management team will positively impact your success in meeting that goal.
Unfortunately, attracting, developing and retaining talent is the bane of every entrepreneur’s existence. I hear the struggles of building out a solid management team: “the unemployment rate is at an all time low and I can’t find anyone who can do the job.” Or one of my favorites: “Nobody wants to work hard anymore.”
I understand, but without a solid management team in place your business will be considered a high-risk investment. The higher the perceived risk in the eyes of a buyer, the lower the price paid. The inverse is true too. Greater quality of management, less risk, higher the price paid.
Step 2: Evaluate the quality of your management team and identify any gaps in talent. Begin with your organization chart. I had a client once who had no marketing director and wondered why sales were so inconsistent. Once you have identified your voids prepare a plan to attract, develop, and retain talent. Strive to make yourself obsolete in your organization. In addition, be sure to have succession plans for key employees in place. This is vital considering how many baby boomers are entering retirement age.
Documented Systems and Procedures:
A well-documented business lowers the perceived risk thus increasing transferable value. An Ocean Tomo study analyzed buyers purchase price motivation and found a whopping 84% of an investor’s purchase price was attributed to an investor buying well-documented intangible assets. It is also important to ensure your accounting is clean and all financial controls are in place.
Step 3: Assess how well your business is documented. Have you clearly documented the operations, how technology is utilized within your business, the approach used to identify, attract, train and retain new talent, the marketing program that drives sales, customer service protocol, financial controls and procedures? How well should your systems and procedures be documented? Clear enough that my grandmother could come in and run your business. Identifying, protecting, defending, and documenting the intangibles will drive your selling price up.
Revenue Character:
Not all revenue is weighted equally in the eyes of a buyer. For example, being paid post project is not as attractive as a model in which the customer pays upfront or incrementally for your service or product.
The real gold standard for an investor is recurring revenue. A buyer is ultimately buying a business for a future predictable revenue stream, which lowers their perceived risk. Lower the risk the higher the premium. Demonstrate recurring revenue streams such as:
- Service Contracts
- Automatic renewal product, service, or content subscriptions
- Strong customer retention rate
Step 4: Analyze your revenue and strengthen any recurring revenue opportunities. When renewing contracts, try to extend the contract for as long as possible and create sticky revenue streams in which a customer needs to come back to repeatedly.
Customer Diversification:
Most investors do not like to see more than 15% of revenue coming from a single customer. This often can be tough for an entrepreneur who nabs the big whale of a client who absorbs all their time. However, a well-diversified customer base further removes risk for an investor. This being said, I spoke with a colleague recently who said they sold a company with just six customers, “Six really good blue chip” customers!
Step 5: Calculate revenue by customer and industry noting profitability. Strive to diversify your base as much as possible with high margin customers. If you find a dominant industry ask for referrals from existing customers to add depth to your customer list. You don’t have to get rid of the big whale just get more of them.
Positive Cash Flow:
Showing an investor that the business is able to fund future growth through current cash flow will go a long way in proving value to a buyer. Be mindful of your growth rate and utilize your working capital efficiently. Working capital measures the company’s operational efficiency and short-term health. It is important to strike a balance. A buyer does not want to see liquidity issues in which they feel they will need to invest heavily in order to realize the growth potential. Conversely, an investor will see excess reserves as under utilizing capital in order to drive revenue.
Step 6: Understand the liquidity of your business by calculating working capital or the current ratio. Current assets divided by current liabilities. A rule of thumb is that a ratio between 1.2-2.0 is considered good, meaning there are enough liquid assets to cover short-term obligations. If the computed current ratio is less than 1.0, liquidity is potentially an issue and a buyer will be concerned about future capital infusion to meet their return on investment expectations. On the contrary if your ratio is greater than 2.0 that may be a red flag indicating that excess assets are not being effectively utilized to maximize revenue. This is a general rule so I recommend researching your industry to understand working capital specific to your business. Once you understand your current working capital position you can then create and execute strategies to improve your cash flow. Positive cash flow = higher price.
All of the decisions made along the way as a business owner builds a business, whether big or small, impact the success of the exit strategy. Focusing on continually increasing transferable value will increase the attractiveness of the business in the eyes of a buyer. This is turn will drive the business owners return on investment for all the time, talent and treasure invested in the business over years!
Cheers,
Chris