Three Common Mistakes Business Owners Make When Selling Their Business: Part 2
Part 2: Business Preparation
So, you are ready to sell your business. Where do you start? Should you put a “for sale” sign in the window and contact the newspaper to attract buyers? I hope common sense is jumping in at this point and a few warning sirens going off.
In the Forbes article “The Business For Sale Marketplace - - Why 90% of Listings Never Sell” (Oct 24, 2016), only 10% of businesses trying to sell actually get to the closing. This information is based on IBBA (International Business Brokers Association) research from polling its members. This is a staggering statistic! Your chances are probably better in Vegas. How are you going to beat the odds? May I suggest good old-fashioned hard work? Develop and implement a plan that gets you to your goals. We will highlight the some of the areas to address and again stress the importance of the “Deal Team” (Mergers & Acquisitions Advisor, M&A Attorney, CPA, Financial Advisors, Business Banker) we talked about in the previous article.
There are many steps involved in this long journey and preparing a business to sell is not a short trip. Buyers and bankers will always dismiss one-year gains (maybe losses) as blip, two years is the start of a trend and threes years is strong trend. With this in mind, you should plan on at least a three-year run up prior to listing your business in order to achieve the best results. The first step is to understand your current value and risk proposition and remember the quality of the information is extremely important if you genuinely want to reach your destination.
You’re ready to sell but does the value of your business meet your expectations? How do you know what your business is worth? Most owners have heard a story about an acquaintance of a friend that sold for some crazy number based on the sales revenue of the company. We can tell you from our decades of experience in the industry that this is the exception, not the norm and while it does happen, this is most likely not the kind of check normal business owners will deposit. Having a business valuation performed is the only way to truly know what your business is worth in today’s marketplace.
Business valuations come in many shapes and sizes. Most business brokers will perform a complimentary valuation, in which they compile a list of comparable companies that sold and the multipliers at which they traded. They will need to understand your financials to ascertain your adjusted EBITDA (Earnings Before Taxes Depreciation & Amortization) or SDE (Sellers Discretionary Earnings). They are trying to determine the free cash flow from the business available to you as the business owner. The industry uses the term “add backs”, and it involves evaluating and noting the financials, then reallocating pretax revenue that is not necessary for normal business operations but is a benefit for the owner. This only half the story.
All businesses sell based on identified risk factors and performance against industry standards. Reduced risk increases the value, increased risk reduces the value. Beating industry averages increases value while underperforming decreases value. Good business valuations completed by a certified valuation analysts (there are several) should, at a minimum, provide:
- in-depth financial analysis,
- multiple valuation models,
- concise industry analysis, and
- business risk.
The report should spotlight the vulnerable areas of your business and provide you with a roadmap to reach your goal. You can focus on the biggest impact areas first and continue to improve the business until you reach your target. Blue Sky performs Business & Market Strategy Guide valuations at a cost-effective annual subscription price with regular quarterly updates, enabling you to track in real time the advances you are making.
The vast majority of small privately held businesses sell on a multiple of EBITDA / SDE in the form of an Asset Purchase not a Stock sale. Buyers prefer to purchase in this manner because it reduces their risk, and they can depreciate the “Blue Sky” portion of the purchase as well as resetting basis on their hard assets. Knowing this, we can focus our efforts on two things: first increase the multiplier and second increase EBITDA / SDE. To increase the multiplier, you must decrease risk and perform within or beat industry averages. Increasing EBITDA can happen in a couple of ways, decrease COG’s / SG&A and or increase revenue. Some common areas of risk mitigation include:
- Audited Financials,
- building management succession team,
- reducing customer and vendor concentration concerns,
- documented processes, and
- legally protected IP / Trademarks.
Audited financials will typically return a full turn on the multiplier. That sounds great, but what does it mean? Well let’s use some fictional numbers, a company earning $2 MM / year in Profit / EBITDA may get a multiplier of 4x. A similar company with audited financials will get 5x, earning the owner an additional $2 MM. Audited financials are significantly more expensive than reviewed or compiled but we hope you are able to see the return on investment. They give buyers confidence not only in your numbers but in your operations, and signal you are an honest businessperson, and the rest of the business should hold up to similar scrutiny.
Building and empowering a strong management team will not only free up your time but it will also improve the value of your company. They will come up with new business models, cost reduction ideas, document processes, and make operational improvements that you may or may not see. Surrounding yourself with strong leaders and listening to your team will significantly impact your business and quality of life. Sophisticated buyers understand that the business is in the best possible position to continue to run without you responsible for every detail.
Concentration issues are an easy trap to fall into and, like most traps, can prove difficult to get out of. Buyers recognize the risk associated with high concentration and will make value assessments based on the degree of risk. We raise the flag when we see customers representing fifteen percent or greater of business revenues and work with owners to, over time, increase sales to new or existing clients lowering the specific concern while growing revenue. The same is true with vendors, if you only have one source for a product or raw material, what happens if they go out of business or cut off your business? Questions like these must be asked because buyers will ask and make value judgements based on these answers.
A transition period is typically associated with every transaction and the length of time is determined by how involved you are in the different facets of the business. This period is the time spent after the transaction is completed. Documented processes for operations, HR, AP, AR, sales, etc., not only increases value, but it will also most likely decrease the amount of time buyers will ask you to dedicate to the transition period.
Hold-backs / Earn-outs are used when buyers are not confident that business operations will continue uninterrupted without you. Buyers are concerned that employees will leave, customers will stop conducting business, vendors will not honor prices or cut the business off, and these are all valid concerns as there is a history of war stories. They can be reduced or eliminated if your business is properly prepared for sell. You may not think this is a “big deal”, but when 30-60% of your purchase price gets tied into an earn out or hold back, it will be. We have heard horror stories of owners walking away from earn outs because they refuse to work with the buyer any longer or worst case the buyer runs the business into the ground. All of this is preventable if you understand not only your goals but how to get there.
Selling your business will most likely be one of the most lucrative and frustrating journeys you will take, you will experience extreme highs and lows throughout the process. Proper preparation will prevent the extremes on either end strengthening not only your value but also your ability to negotiate the softer terms that are important to you. At Blue Sky we have worked with owners to help them realize their dreams and goals, navigating dark and murky water when necessary and achieving things they did not think were possible when we started working with them. The best results are always realized when a plan is in place and course corrections are made on routine basis.