Musings From Ron

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I send these emails periodically to accomplish two purposes – to pass along a little knowledge about how to prepare a business for sale and to promote the fact that I do this kind of work for a living. This time, rather than stick to a single basic theme, I have chosen to discuss several random points – musings if you will – on the ways business owners can prepare for what is often the most important event in their lives – selling their company.

DOCUMENT THE VISION

home-working-manI ran across this phrase in the Wall Street Journal a while ago and it resonated with me. “Document the Vision.” As a business owner, it is crucial that you articulate the vision you have for your company. You probably have at least a general idea of where your company is headed. Some have chosen to share this with key members of their management teams and others prefer to keep it to themselves. When it comes time to sell, your buyers will be eager to know your vision too. I spend a lot of time with owners helping them document their vision. It’s one thing to say you want to increase Sales and Profits. Now it’s time to create a Financial Model to actually show how it is going to work. Now it’s time to not only forecast what you expect but to explain how you are going to get there.

The models I create for clients include Income Statements, Balance Sheets and Cash Flow Statements. Why all of those numbers? Because buyers need to understand what it’s going to take to achieve the forecasted Sales and Profits in terms of Capital Expenditures, Additional Financing, Receivables and Payables. We create subsidiary schedules that may include Sales by Customer and/or Product, Employee List, CapEx/ Depreciation, Cost Breakdowns, etc. This is the kind of documentation that is necessary. Buyers will never agree with everything but they will insist on knowing the “view from your window”. I will also help prepare a full narrative to support this financial model.

Document your vision. Buyers need it in order to fully understand your company.

MANAGEMENT SUCCESSION

Real estate buyers, it is often said, are only interested in three things – location, location and location. Similarly, company-buyers are also interested in “only” three things – management, management and management.

When contemplating the sale of a business, the owner must ask himself, “Who in my company will replace me after I leave? And for that matter, who is going to replace other key managers, too”?

I have run into too many business owners who are proud of the fact that nobody knows as much as they do. I have seen too many companies with flat Organization Charts. Everybody reports to the owner and, often, no one is being groomed to take over. I have also seen too many companies with no Organization Chart at all, but that’s another story.

Selling a company is the time when owners should suppress their egos. When walking through the business with potential buyers, look for opportunities to step back. Invite managers to answer buyers’ questions. Welcome managers into formal and informal presentations to buyers. Ask managers to explain various elements of the company’s operations.

I have seen buyers walk away from deals because of the lack of management depth. It is vital not to underestimate the importance of empowering a strong team of managers to help lead the company under the new owners.

EARNOUTS

bargraph-moneyAn Earnout is a technique that can bridge a perceived value gap between buyer and seller. It starts when the seller shares the company’s forecast during the price negotiation phase. “How”, the seller asks, ” can you not agree to pay my price for the business when you can see it’s going to make these sales and profits”? The buyer responds, “The problem is that I don’t think the company is going to do that much business and earn those kinds of profits. If I did, I would pay your price.” What ensues a conversation in which it is suggested that a contingent payment be negotiated whereby if those sales/profits are achieved, and only if they are achieved, extra compensation will be forthcoming. That contingent payment is called an Earnout.

Earnouts are much maligned these days with many saying that they get too complicated and that sellers often do not get the payments. That has not been my experience. I find Earnouts to be an excellent way to balance a deal and careful wording can ensure an arrangement that is fair to both parties. For Earnouts that are based on Income Statement performance, buyers tend to prefer that they be based on bottom line Earnings performance and sellers prefer them to be based on top line Revenue. Sellers shy away from the bottom line because they do not want buyers to be able to spend money on big bonuses, for instance, rather than pay the seller an Earnout. This can easily be solved by basing Earnouts on a level of profit in between the top and bottom lines, like Gross Profit (Sales less Cost of Good Sold) or an artificial profit based on an agreed-upon formula of certain revenues and certain costs.

There are many creative ways to construct an Earnout formula that are fair and balanced and it is an excellent method to solve price issues.

DOCUMENTED PAST/CREDIBLE FUTURE

Companies are purchased not because of what they did do but rather because of what they are expected to do under new ownership. One does not buy a stock because it once was worth $100 but rather because the buyer expects it to reach $100 at some point in the future. But in companies, as with stocks, history can be instructive. It gives one further hope that it can reach $100 again. The past is important because it is an indicator of the future.

Sellers do not want to offer their income tax returns as evidence of past performance – tax returns make income look low. Most of the time, income strictly from the company’s books is also not the version of income sellers will want to express. Sellers will want to “recast” their book income to express it as if it were a publicly held company by adding back “excessive owner’s compensation”, country club dues, personal expenses, etc.

Buyers want sellers to do that. They want to know the true earning power of the enterprise and you should provide them with this information along with supporting details that explain the recasts.

What figures do sellers start with when making these calculations? Owner-prepared statements are considered to be the least reliable and audited statements the most reliable. Small companies typically do not have audited statements and they are not expected to. The objective is to well-document past performance and the highest level of affordable, independent, accounting professional assistance to get to that point should be used.

As mentioned above, all buyers want to know the sellers’ forecasts even though these will rarely use those forecasts exactly as presented to arrive at a valuation. Sellers will not serve themselves well by presenting forecasts that are not supported by a reasonable rationale. The forecasts need to be credible and supported with as many facts as possible. Detailed analyses as outlined above will be very helpful.

A well-documented past and a rational, detailed, credible forecast will, in the final analysis, add value to the company.