Timing the Sale of Your Business

by Peter C. King, VR Business Brokers/Mergers & Acquisitions, CEO

In a perfect world, business owners sell their companies when banks are anxious to lend, the economy is strong, their industry is booming and the business is enjoying record profitability, with the future looking even brighter. Naturally, a perfect convergence of all these variables would enable you to maximize the value of your business allowing you to sell it at the highest price and on the best terms.

But most business owners don’t sell when market conditions are perfect. Instead, they make the decision for more personal reasons, such as retirement or to free up cash to pursue other investment opportunities. Unfortunately, many businesses are sold when the owner dies unexpectedly or is otherwise unable to run the business. These unplanned events increase the chance that the business will realize a lower selling price than it would in better circumstances.

QUESTIONS TO ASK

Before you make the decision to sell, you need to ask yourself several questions. First, how motivated are you to sell? Selling a business is an arduous process that can take a year or more from the initial valuation to finding a buyer to finalizing the deal.

Second, have you adequately prepared your business to be sold? Most experts agree that owners should plan for the sale of their business at least three years in advance. You may even want to plan for an eventual sale as you’re still establishing and building your business.

But even if you have no current plans to sell, managing your company as if it will be sold is likely to result in a more efficient, financially viable business. For example, your business plan whether a formal or informal document should evaluate growth opportunities, market position, and business goals, and explain how progress in reaching these goals will be measured. Not only is your business plan an important tool in unlocking the current value in your company, but it also serves as initial prospectus for prospective buyers.

INTERNAL AND EXTERNAL FACTORS

Keeping an eye on economic cycles and how they affect the merger and acquisition market is important. The market for privately owned companies can be just cyclical as that for publicly traded companies. Economic recessions, for example, generally mean there are fewer buyers. General economic weakness can also result in a drop in your business’s profitability and a perception among buyers that your business is a risky acquisition.

Also be aware of your business’s growth cycle and plan to sell when sales growth has reached a peak. Of course, this isn’t always easy to calculate, and typically requires the help of outside advisors. Further, you are better positioned to sell if your company boasts valuable patents, brands, proprietary products or a lucrative market niche.

Businesses are typically valued on a multiple of earnings. Your business’s earnings, therefore, must be transparent and documented. Many deals are funded with bank debt, and most lenders won’t finance a transaction without stable cash flows that can be verified through solid financial statements. Buyers also usually look for breadth of management because it reduces the company’s dependence on the departing owner and allows the buyer to learn the business from an experienced management team.

There are also a number of relatively minor things you can do to enhance the perceived value of your company and make it more attractive to purchasers. Cleaning up and organizing the office, factory and warehouse space is an inexpensive enhancement. Repairing or replacing equipment may cost a bit more, but will help you attract buyers seeking a turnkey operation. Finally, consider disposing of unproductive assets or old inventory that buyers don’t want to be burdened with.

MAXIMIZING YOUR SELLING PRICE

Selling your business can be time-consuming a complex process, but you’re likely to maximize your selling price by planning the event well in advance and by engaging qualified advisors to assist you. While a deal can often be put together quickly, maximizing value means that selling your business may take time. Remember, you don’t want to feel pressured to take the first offer, or to accept terms that are less favorable.

 

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Why You Should Exit While You’re Ahead – A Cautionary Tale

The very best time to sell your business is when someone wants to buy it. While it can be tempting to continue to grow your business forever – particularly when things are going well — that decision comes with a significant downside.

Take a look at the story of Rand Fishkin who started his entrepreneurial journey when he joined his mother’s marketing agency as a partner:

When Fishkin realized how much his Mom’s customers were struggling to get Google to display their company in a search, he immersed himself in the emerging field of Search Engine Optimization (SEO).

He began writing a blog called SEO Moz, which led to an SEO consulting and software company. By 2007, Moz was generating revenue of $850,000 a year when Fishkin decided to drop consulting to become solely a software business.

The company began to grow 100% per year and by 2010, Moz was generating around $650,000 in revenue each month, attracting the attention of Brian Halligan, co-founder of marketing software giant HubSpot.

HubSpot wanted to buy Moz and was offering $25 million of cash and HubSpot stock – an offer almost five times Moz’s $5.7 million of revenue in its last complete financial year.

But Fishkin wasn’t satisfied. He believed a fast growth Software-as-a-Service (SaaS) company was worth four times future revenue and was confident Moz would hit $10 million by the end of that year.

Fishkin counter offered, saying he would be willing to accept $40 million. HubSpot declined.

New Plans Ahead

Instead of selling Moz, Fishkin raised a round of venture capital and started to diversify away from SEO tools into a broader set of marketing offerings. The further Moz veered away from its core in SEO, the more money his business began to lose.

By 2014, Moz was in full crisis mode, and Fishkin had begun suffering from a bout of depression. He decided to step down as CEO, describing his resignation as a “lot of sadness, a heap of regrets and a smattering of resentment.”

Fishkin became a minority shareholder in a company he no longer controlled where the venture capitalists had preferred rights in a liquidity event.

A Lesson Learned

In the ensuing years since turning down Halligan’s offer, HubSpot went public on the New York Stock Exchange and had been worth nearly 20 times as much.

Fishkin revealed that today, his liquid net worth is $800,000 – much of which he was about to spend on elder care for his grandparents. The Moz stock he holds may or may not have value after the venture capitalist get their preferred return. At the same time, Fishkin estimated HubSpot’s offer of $25 million in cash and HubSpot stock would now be worth more than $100 million (based on the increased value of HubSpot’s stock).

Fishkin’s tale is a cautionary reminder why the best time to sell your company is when someone wants to buy it – a story that is shared in his book Lost and Founder: A Painfully Honest Field Guide to the Startup World.

What if an offer was made for your business today? Would you be ready to sell? Would you regret if you said no?

 

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Leaving a Legacy: Why Some Sellers Choose ESOPs

Article written by Arielle Shnaidman and provided courtesy of Axial.net 

While Employee Stock Ownership Plans (ESOPs) have long been good exit options for smaller companies, in the last few years larger middle market businesses have started considering ESOPs as an exit strategy as well. Companies worth hundreds of millions of dollars that could have easily sold to private equity firms have opted to go the ESOP route. An ESOP allows employees to buy an interest in a company while at the same time giving the owner liquidity. 

Alberto Toribio del Pilar, a managing director with the St. Louis, Missouri-based boutique investment bank ButcherJoseph believes owners of larger companies are more frequently considering ESOPs because they are becoming a more proven way to realize meaningful value at closing while implementing a significant employee retirement benefit. 

As a firm, ButcherJoseph has a niche focus on ESOPs. The key tax advantage of this exit option is the ability for a seller (under the right circumstances) to defer capital gains tax on the sale of their business to an ESOP. ButcherJoseph works with sellers to figure out how to best structure their deal to get those tax advantages based on the market value of the business. These types of deals require the business to borrow money — usually against the assets or cash flow of the business — which is why companies with many assets to borrow against or healthy margins are typically a good fit for an ESOP exit strategy. 

For example, Nation Safe Drivers (NSD), a roadside assistance company, recently completed an ESOP in Boca Raton, Florida with ButcherJoseph’s help. “We explored several exit strategies, and we were by far the most intrigued with Employee Stock Ownership Plans. Our company has tremendous potential, and we wanted to share this future success with the dedicated employees who will continue growing NSD,” said Andrew Smith, NSD CEO in the press release.   

Leaving a Legacy 

At first glance, the clear tax advantages of an ESOP exit option for business owners seems like reason enough to pursue this option. However, tax benefits are rarely the only reason sellers pursue this option. 

“Maximizing cash at close is typically not the most important element of the deal for sellers in most of these cases, because these folks already have money,” says del Pilar. “They think about the ESOP structure because it’s an amazing opportunity for their employees.” ESOPs are not often the most lucrative option for the seller. First, while offering fair market value, ESOPs typically cannot match the high multiples offered by private equity firms. Sellers of an asset-heavy business could also see a bigger return by dissolving the company and selling off the assets. 

But for business owners who have put their blood, sweat and tears into building a company for many years, money isn’t necessarily the only factor when it comes time to exit. 

An ESOP allows employees to secure a portion of their retirement investment through their work and ownership. For example, ButcherJoseph worked with a 35-year-old Midwest-based aviation business on an ESOP. 

The business could have sold off its assets, which were worth more than the business as a whole, but the owner wanted to make sure his employees were taken care of. He was a highly-regarded figure in his community with family in the business along with tenured employees and a large technical group of mechanics who took care of the aircrafts. He didn’t want his company bought and relocated. For these reasons, selling his business to a private equity firm or competitor was not an option. 

The owner of the business worked with ButcherJoseph for several months to structure the deal. This involved working out management incentive plans to create an environment for performance and ensuring the owner would receive a certain amount of income after close. After the seller realized value at closing, he positioned himself as a creditor by providing seller financing. As a lender he receives principal and interest for the remaining value of his business at closing. 

Potential Risks 

Typically, ESOPs work best for companies that have strong, tenured management teams that can run the business efficiently after the owner exits. Additionally, companies should have a good collateral base with healthy margins to borrow against for the ESOP structure. The underlying business should be relatively solid and not subject to peaks and troughs. 

While ESOPs are good exit options for many, deals can go wrong if they’re not structured correctly. If the deal is done at too high of a valuation, or companies violate covenants with lenders, the deal can go south. Finally, selling the business, but not transferring control is also a way to run a foul with the rules and regulations governing ESOPs. A true board or voting mechanism needs to be put in place to ensure proper corporate governance. 

 

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Number of Small Businesses Changing Hands Dips Slightly, But Market Remains Ripe for Buyers & Sellers

Small business transactions in the first quarter of 2019 experienced a modest year-over-year decline but remain at historically high levels, according to the latest BizBuySell Insight Report, a nationally recognized economic indicator that aggregates statistics from business-for-sale transactions reported by participating business brokers nationwide. A total of 2,504 sold businesses were reported in the first three months of 2019, a 6.5% decline from the same period last year. Similarly, Q4 2018 saw a 6% decrease from the same quarter in 2017. 

It is important to note that both 2017 and 2018 set new records for the most annual small business transactions since BizBuySell started reporting the data in 2007. So while reported deals are down slightly from a year ago, the market continues to be very active compared to the previous decade. In fact, Q1 2019 represents the second highest first quarter on record, trailing only 2018. It is too early to tell if the recent plateau marks any kind of market shift or not. To gain additional perspective, BizBuySell also surveyed business owners and some leading brokers, the results of which are incorporated within this report. 

A number of factors could be tempering the strong transaction growth rates seen in recent years. Most notably, these include the recent government shutdown, low unemployment, record profits, deal financing, and general uncertainty around the impact of administration policies relating to tariffs, immigration, and health care. 

“Main Street business sales may have been impacted in part due to a stronger economy where individuals are more satisfied as employees (not looking to purchase businesses) and business owners are seeing higher profits (not looking to sell their businesses)”, said Jeff Snell, Chairman of the International Business Broker Association, the industry’s leading trade group. “Also, time to complete business transactions has increased marginally, potentially as a result of the Federal Government budget shut down which closed SBA loan guarantee processing offices. However, broker optimism through 2019 remains strong”, Snell added. 

“The business sale market still continues to perform strong in 2019 in terms of number of deals getting done and the multiples sellers are receiving. However, we are seeing signs that the market could become more challenging in the future with interest rates rising and financing becoming both more expensive and harder to acquire. This can make the buyer process lengthy and more difficult, which would suppress multiples and extend time to close”, said Jessica Fialkovich, President, Transworld Business Advisors of Denver. 

Of course, it is also possible the past two quarters have been outliers and 2019 will continue on its multi-year growth trend in upcoming quarters. It is something to watch closely as data comes in over the rest of the year. Inventory remains strong, with a 6.1% increase in listings in Q1 over the same quarter last year. 

“After several years of record activity, it’s good to see that there are still plenty of listings coming on to the market, so the small decrease in activity may be more about buyers taking a cautious approach than a slowdown in the supply,” Bob House, President of BizBuySell.com & BizQuest.com, said. 

 

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The One Number Owners Need to Stop Focusing On

The value of your business comes down to a single equation: what multiple of your profit is an acquirer willing to pay for your company?

profit × multiple = value

Most owners believe the best way to improve the value of their company is to make more profit – so, they find ways to sell more and more. As experts in their industry, it’s natural that customers want to personally engage with them, which means spending more time on the phones, on the road and face-to-face to increase sales.

With this model, a company can slightly grow, but the owner’s life becomes much more difficult: customers demand more time and service, employees begin to burn out, and soon it feels like there are not enough hours in the day. Revenue flat lines, health can suffer and relationships get strained – all from working too much. Does this feel familiar?

If you’re spending too much time and effort on increasing your profit, you could find yourself diminishing the overall value of your business. The solution? Focus on driving your multiple (the other number in the equation above). Driving your multiple will ultimately help you grow your company value, improve your profit and redeem your freedom.

What Drives Your Multiple

Differentiated Market Position

Acquirers only buy what they could not easily create, so expect to be paid more if you have close to a monopoly on what you sell and/or are one of the few companies who have been licensed to provide the specific product or service in your market.

Lots of Runway

Most founders think market share is something to strive for, but in the eyes of an acquirer, it can decrease the value of your business because you’ve already sopped up most of the opportunity.

Recurring Revenue

An acquirer is going to want to know how your business will do once you leave – recurring revenue assures them that there will still be a business once the founder hits eject.

Financials

The size and profitability of your company will matter to investors. So will the quality of your bookkeeping.

The You Factor

The most valuable businesses can thrive without their owners. The inverse is also true because the most valuable businesses are masters of independence.

 

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How to Reduce Owner Dependence Before a Sale

Article written by Meghan Daniels and provided courtesy of Axial.net

CEOs: What would happen if you went on vacation for a month and left your business to run itself?

If your answer is “everything would fall apart,” or “what’s a vacation?” chances are good that your business is highly dependent on you. This may not seem like a problem now, but when it comes time to think about selling your business, it may well be.

“Contrary to popular belief, buyers are highly risk-averse,” says Steve Raymond, Managing Director of New Jersey-based investment bank The DAK Group. Owner dependence (or dependence on any key person) is a major driver of risk, and as such can mean sellers don’t get the price or terms they want during a transaction.

Robert Rough, Managing Director of Dallas-based investment bank Telos Capital Advisors, says that smaller companies tend to be more owner-dependent. There are also certain types of businesses — e.g., dentists’ offices, insurance agencies, or law firms — where “the owner is almost always a major rainmaker. It all comes down to what role the owner plays, for example how involved he or she is in customer relationships and sales,” says Rough.

If you’re thinking about selling your business, here are a few suggestions to help mitigate the risk of owner dependence.

1. Make moves well in advance of a desired sale.  
When Jim O’Keefe, the founder of Wisconsin-based commercial millwork manufacturer O’Keefe, started thinking about planning for an exit, he had a clear life goal of being completely out of the business by the time he was 65 years old. “He’d started the business when he was in his early 20s and built it out of his garage,” says Dan Mulvaney of Sunbelt Midwest Business Advisors, which advised O’Keefe. Five years out from his desired sale timeline, “he brought in professional management and went from running the business to being an absentee owner, which added a lot of value to the business.”

O’Keefe ended up selling to Ninth Street Capital Partners, a middle market private equity fund based in Cleveland. The connection was made on Axial. The process was highly competitive in large part due to Jim O’Keefe’s prudence in stepping back early. “When we bring a business to market that has a management team in place that will stay post-closing for a long time, that broadens the market dramatically amongst buyers. A lot of buyers have the cash, but they don’t have the talent or operator who can jump in full-time and take over for the business owner,” says Mulvaney.

2. Bring in an independent board.
“Generally speaking, if you’re going to be selling a business within a year, you don’t have enough time to bring in a board,” says Raymond. But for those with enough lead time, creating a board is a great way to mitigate risk for a potential buyer by ensuring long-term business continuity. Board members also bring in outside perspectives and experiences that can improve business practices and help owners and existing management identify and address any challenges in the company. While there may be resistance to the idea, independent boards can be particularly helpful for family businesses, where long-established dynamics and a lack of outside experience can sometimes obstruct a business’s full potential.

3. Build out the management team.
“A lot of privately held businesses operate without a true CFO, somebody who understands treasury and sophisticated financial reporting. Bringing in a CFO is an easy step that can be done in a short time frame,” says Raymond. Bringing in a COO is also an option, although sometimes that can be done concurrently with the transaction. “Buyers, particularly PE buyers, will sometimes want to bring in an outside expert as part of the deal to help mitigate the risk, usually referred to as operating partner.”

In some cases, the business may not be large enough to justify bringing in either a CFO or a COO. In these cases, Rough recommends working on addressing areas of the business that will directly impact revenue first. “Customer relationships and sales are probably the most worrisome areas for a potential buyer,” says Rough. “Most buyers will be able to find someone to manage the books and keep the trains running on time. But they want to make sure that they won’t lose revenue. You want to make sure that there’s someone in the company who will be staying and can ensure continuity for key relationships.”

In general, think about delegating and distributing responsibilities. “If the owner just decides to replace themselves with a younger version of themselves, that doesn’t necessarily solve the problem,” says Rough.

4. Document key information.
Business processes shouldn’t just live in your head. If you go to Tahiti for two weeks, your team should know how to keep things running and have all the information they need to make informed decisions. Prospective buyers will want to see that these processes are well-documented to make knowledge easier to transfer post-close.

Owner dependence is just one issue in a business, but it’s often tied up with other risks that buyers discover in due diligence — lack of a true management team, a shaky handle on financials, intellectual property concerns, problematic legal agreements with customers or vendors, etc. As a seller, the more you think through these problems and take steps to address them in advance of a sale, the more likely you are to achieve the valuation and terms you’re looking for. Consulting with an investment banker or advisor before you want to bring your market is the first step and can help you evaluate where you are and what areas you should address first. “The more a company professionalizes their business and looks internally before a sale, the more interest they’ll get from buyers and the more likely they are ultimately to close a deal,” says Raymond.

 

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Valuation vs. Terms in a Business Sale

This article is provided by Brent Beshore, courtesy of Axial.net.

The following is an excerpt from investor Brent Beshore’s recent book, The Messy Marketplace: Selling Your Business in a World of Imperfect Buyers. Beshore is founder and CEO of adventur.es, a Midwestern-based permanent equity firm. 

As a seller, it can be easy to fixate on the numbers. “My business is worth X. I’m going to get Y cash at close.” These figures will represent some of the largest you’ve seen in your lifetime. The focus on valuation is understandable, but remember that structure and terms are equally important in negotiation.

When negotiating with a qualified and trustworthy investor (a.k.a. the type of buyer you probably want), you should take advantage of their expertise. While this may seem counterintuitive, they have spent their careers understanding creative ways to structure a deal, from responsible options and uses of debt to how to properly incentivize existing leadership to ensure a smooth transition. Your best path is to tell them what is important to you and why, and also what you recognize to be the risks in the deal. Then let them explain what options may satisfy both parties best. To be clear, I’m not suggesting blind trust in a buyer regardless of reputation, or your intuition. Always approach a proposed solution with open-minded skepticism.

To illustrate, here are a handful of scenarios:

QUICK EXIT: You tell the buyer that you will only consider an offer that provides all cash at close because of grave health concerns. Immediate liquidity is priority number one. You are asking the buyer to assume all responsibility and liability for not only the future prospects of the organization, but also the transition post-close. The buyer will apply a discount and the resulting valuation will likely be substantially less than a deal with more structure over a longer time period.

MARKET-BASED EXIT: You tell the buyer that you have a target valuation range, providing research that backs up why you believe it is reasonable for your business. The buyer will compare your research against their own, and also the circumstances of your company. Sellers sometimes bring forth research on industry-relevant com- panies unrelated in scale, leadership depth, and earnings history, which a buyer will quickly disregard. If the research is valid, how- ever, the buyer will likely calculate a similar valuation range (it may not be exactly the same, but they’ll tell you why) and focus on structure and terms. What percentage will be earned out to ensure performance? What guarantees will be outlined about key employees and customers?

BRIGHT FUTURE EXIT: You tell the buyer the company is set up for future growth, you have confidence in the projections provided, and, while you need some immediate liquidity, you want to share in the upside. The buyer will structure the deal to share risk and reward.

Valuation and terms for each of these exit scenarios will be varied, and that’s a good thing. They’re creative solutions. It’s key to remember what’s important to you and evaluate the options against those criteria. And above all, communicate your interests clearly.

There are no hard rules in valuation. A buyer doesn’t have to match another buyer’s offer, accept your presented adjustments, or meet your demands on timeline or payment structure in their offer. And, you don’t have to sell. Every value and formula is negotiable.

 

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EBITDA Engineering Before Selling a Business


Source: FeelPic/iStock

Takeaway: Take control of your financial statement by learning how accounting policies can positively impact EBITDA.

This article written by John Carvalho, president and founder of Stone Oak Capital Inc., an M&A advisory firm, as well as a co-founder of Divestopedia

EBITDA is a commonly used metric for the valuation of mid-market businesses. Now, the appropriateness of using EBITDA can be debated, but the fact is that most estimates of business value start with this number. So needless to say, increasing EBITDA will increase the value of a business.

Most often, business owners of privately held companies are motivated to minimize taxes. They will try to expense as much as possible and even defer recording revenue to reduce taxable income. Business brokers or investment bankers will often normalize the results of a vendor’s financial statements for nonrecurring or one-time costs. These normalizations are scrutinized by potential buyers and often rejected as legitimate adjustments. On the other hand, EBITDA (before normalizations) calculated from financial statements that are prepared by an external accountant receive much less scrutiny from the prospective buyer.

To this end, business owners should consider how their accounting policies are impacting EBITDA. The truth is that business owners can choose between various accepted accounting methods to show higher EBITDA on their externally prepared financial statement and thus positively impact business value. Some people may consider this to be financial engineering, which carries a negative connotation. I consider it to be smart exit planning.

Selection of Accounting Principles

Accounting principles are rarely black and white. There is a significant amount of gray in determining how to record a transaction. Let’s thank Luca Pacioli, the father of accounting, for the double entry system of bookkeeping that has been used for over four centuries. In its simplest form, cash outlays can be recorded as an expense on the income statement or as some sort of assets on the balance sheet. Comparatively, cash inflows can be recorded as revenue or some sort of liability (or equity) on the balance sheet. There is significant judgment and flexibility that goes into recording each transaction. This, of course, can have a material impact on the EBITDA of a business.

Here are five common accounting policy selections that can be managed to increase EBITDA:

Capital Leases versus Operating Leases

One on the biggest knocks against EBITDA as a valuation metric is that it is supposed to reflect a company’s cash flow, but it does not consider the requirement for capital expenditures. Warren Buffett, in his criticism of EBITDA, is credited as saying, “Does management think the tooth fairy pays for capital expenditures?” Regardless of your stance on EBITDA, capital asset expenditures are not considered in the calculation of EBITDA, but depreciation and amortization is added back.

If your company is capital intensive, recording equipment leases as capital versus operating will improve EBITDA. For operating leases, rental payments are expensed on the income statement and therefore reduce earnings. On the other hand, if a lease is recorded as a capital lease, the assets are recorded on the balance sheet and depreciated over time. The related liability is recorded as debt on the balance sheet and the interest is expensed on the income statement. Payments toward the capital lease are not expensed and instead are recorded against the liability which would not impact earning. Also depreciation on the asset and interest on the debt are added back, therefore EBITDA would be higher.

Capitalization

Another method to increase EBITDA is to be more aggressive on capitalization of costs, which means moving cash outlays from being recorded as an expense on the income statement to an asset on the balance sheet. This has two positive effects: The first is that it strengthens your balance sheet by showing more assets; the second is reducing expenses and increase EBITDA.

A transaction can be capitalized if it extends the useful life of a capital asset. Significant repairs and maintenance costs are often expensed in privately held businesses to reduce net income and, correspondingly, income tax at the detriment of higher EBITDA.

Costs that have future economic value that can be measured might also be eligible for capitalization. As an example, wages paid to employees for the development of a new software can be added to the cost of that implementation. Capitalization of costs is a gray area that requires just as much qualitative justification as quantitative.

Inventory

Many privately held businesses will hold inventory even though it is fully expensed when purchased. A periodic inventory count can move the inventory still sitting in the shop or warehouse off of the income statement and on to the balance sheet. This has the immediate effect of increasing EBITDA and also, from a financial reporting perspective, presents a more realistic picture of the working capital required to operate the business.

Revenue Recognition

Revenue recognition is an accounting principle that determines the specific conditions under which revenue is recognized or accounted for. Revenues are recognized when they are earned and corresponding expenses are recorded to match that timing. But when is the revenue actually earned?

Many businesses will record revenue when a project is completed, but there are many instances when partially completed jobs will straddle a company’s year-end. If revenue was recognized for the percentage of the work completed on those projects, the profit margin would be recorded on the income statement and increase EBITDA for that period.

Cut-off

Cut-off relates to whether transactions and events have been recorded in the correct accounting period. Moving certain transactions from one period to the next can have a significant impact on EBITDA. For example, delaying major purchases or taking delivery of major items after year-end can push costs to the subsequent year and thus increase EBITDA. The same is true on the revenue side if a company is able to close a major deal or make a large shipment to a customer prior to a year-end.

Own Your Financial Statement

Let me be clear that I am not suggesting perpetrating fraud or any sort of misrepresentation that could mislead a potential buyer; I am merely suggesting that selection and knowledge of accounting policies can have a significant impact on EBITDA and, consequently, the determination of a company’s value during a sale process. I see too many business owners blindly accept the adjustments that are presented to them by their external accountants. Your company’s financial statement are exactly that — yours! You should have significant input into the policies used in their creation and the ending results that they communicate to outside stakeholders.

 

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The Biggest Mistake Owners Make When Selling

One of the biggest mistake owners make in selling their company is being lured into a proprietary deal.

The Definition Of A Proprietary Deal

Acquirers land a proprietary deal (or “prop deal”) when they convince owners to sell their businesses without creating a competitive marketplace. Acquirers running a proprietary deal know they don’t have any competition and tend to make weaker offers with more punitive terms because they know nobody else is bidding.

Many founders become the target of a proprietary deal without even knowing they have been duped. First, someone senior from the acquiring company approaches the founder, complimenting them on their business. The acquirer suggests lunch, and then high-level financials are exchanged. Soon, the owner starts going down a path that is difficult to come back from.

As the parties in a proprietary deal get to know one another, founders often share information with the acquirer that puts them in a compromised negotiation position. The interactions are set up as friendly exchanges between two industry leaders, but many founders reveal key facts in these discussions that end up being used against them when negotiations turn serious. Business owners also become more emotionally committed to selling the more resources they invest in the process and the more time they spend thinking—perhaps dreaming—of what it would mean to sell their business.

How To Avoid Getting Taken In By A Proprietary Deal

Savvy sellers avoid the proprietary deal by creating a competitive process for their company. Take for example Dan Martell, the founder of Clarity.fm, among other companies. When Martell decided to sell Clarity, he knew the likely buyer was one of five New York-based companies. Instead of negotiating with one, he invited all five to an event he hosted in New York. The five CEOs—all of whom knew one another—saw a room full of their competitors and realized that if Clarity went on the market, they would have to out-bid the other buyers in that room.

Hosting the event was Martell’s way of communicating to all the potential buyers that a proprietary deal was off the table and that if they wanted to buy Clarity, they would have to compete for it.

It’s flattering to receive a call from an executive at a company you respect. Just know that if you accept their invitation of lunch, you run the risk of becoming the latest casualty of the proprietary deal.

 

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The Initial Price May Not Be Real

The following article written by Paris Aden of Valitas Capital Partners.

Takeaway: The Due Diligence Grind is often practiced by sophisticated acquirers to reduce the purchase price of a business by citing negative findings during due diligence.

The initial dollar figure presented as a purchase price for a business, whether written on a napkin over coffee or floated in a conversation, is not a binding offer. Any potential acquirer will need to conduct a due diligence investigation before they can enter into a definitive agreement to buy your business. Initial indications can be tactically inflated to ensure the acquirer gains access to your confidential information after which this price is systematically reduced, citing negative findings during due diligence — also known as “The Due Diligence Grind”. The most effective antidotes are preparation and competitive tension. Let’s take a closer look at how a prospective buyer can grind down the purchase price.

Due Diligence Becomes a Reactive Process for the Seller

Whether you have received a preliminary proposal from a single party who approached you or you’ve received several non-binding bids through a structured auction process, the nature of the process changes from proactive to reactive as due diligence progresses. Ultimately, each bidder will have different due diligence requirements and the onus is on the seller to satisfy those requirements (or not). The due diligence stage is the acquirer’s opportunity to investigate the business from top to bottom. Although difficult, it is essential to maintain control of the process, despite your reactive position during this phase of the process.

How Due Diligence Increases Transaction Risk and Impacts Valuation

The purpose of due diligence is for the acquirer to conduct his or her own assessment of the value of your business and to confirm their initial assumptions. As you submit information about your business to a potential acquirer, they will investigate potential risks, including validating information that may have been presented to them earlier in the process. Due diligence is an essential step for the acquirer to make a binding commitment to a price and to inform the negotiation of the definitive agreement. However, savvy acquirers are skillful at gaming this process to their advantage.

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Potential acquirers can by cynical. A key due diligence objective is lowering the price of the business by focusing on its flaws. Imagine a customer listing a litany of complaints or deficiencies about your product or service as you are presenting your case for a routine pricing increase. Potential acquirers may attempt to reduce the value of the business either explicitly, by reducing the headline price or, indirectly, by revealing transaction terms that erode the value you receive.

Headline Price Adjustments via Valuation Metrics

Private businesses are routinely valued as a multiple of a particular financial metric. One of the more commonly used metrics is earnings before interest, taxes, depreciation and amortization (EBITDA). Adjustments are commonly applied to normalize EBITDA for what it would be in the hands of the new owner. These metrics are reported as part of the preliminary documentation and are scrutinized heavily during the due diligence process. The acquirer will typically seek to expose weaknesses in the information and rationale for the normalization adjustments to make a case that the metric is inflated. A few examples include:

  • Accounting Policies: Suggesting accounting policies, such as revenue recognition, allowance for doubtful accounts or capitalization policy are too aggressive.
  • Normalization Adjustments: Suggesting that non-recurring normalization adjustments really are normal-course business, that market value of the owner’s compensation is understated, that certain expense savings really are buyer synergies that are not appropriate for stand-alone valuation.
  • Budgets and Forecasts: Often the valuation is based on a forward metric, such as forecast EBITDA. The seller’s forecast assumptions may be deemed too optimistic, or as we Canadians like to describe it, a “hockey stick forecast”, where projected growth is out of line with historical growth.

Given that the headline value is simply the product of the valuation metric and the valuation multiple, a reduction in the metric will have a proportionate impact on the headline price.

Headline Price Adjustments via the Multiple

Though less common that a negative revision to the metric, a bidder may suggest they have justification to reduce the multiple they have applied in their initial valuation assumptions because of newly identified/revised risks that they claim they were not aware of earlier. There are generally four reasons the valuation multiple may be reduced, the first three of which are specific to the business:

  1. Greater business risk, such as poor quality of earnings;
  2. Lower expected growth as a result of improperly supported growth forecasts;
  3. Reduced free cash flow conversion expectations, such as higher than expected capital expenditure or working capital requirements; or
  4. Deterioration in market conditions, such as a drop in capital markets valuations or tightening credit.

Adjustments to the Transaction Terms

Negative revisions can also manifest in the deal terms. This can be more difficult to control because such details are usually ignored as part of the “business deal” and left for the lawyers. The acquirer may claim due diligence findings that require terms that either erode the value of the headline price or significantly shift risk to the seller. Examples include:

  • Shifting Risk to the Seller: Out-of-market representations and warrantiesindemnities or hold-backs. For example, an acquirer may agree on the ‘price tag’ of the deal, but add a condition that if the seller misses the five-year forecast by one dollar, the price paid will be reduced by 50%.
  • Changing the Form of Consideration: That firm cash price may become payable in IOU’s and store coupons. A portion of the price may become contingent on performance of the business post-closing, i.e. as an earnout.
  • Working Capital: This one is a favorite! Instead of delivering the business with a level of working capital appropriate to operate the business in the normal course, you are presented with a convoluted adjustment mechanism that suggests the business should be delivered with more working capital than needed, resulting in a negative price revision for you post-closing. Or the most egregious of working capital manipulation, the cash dam.
  • Effective Date: Seems innocent enough. Let’s make the effective date at the beginning of this year. The problem is that all of that free cash flow from the effective date until closing now belongs to the acquirer. Another effective reduction in the purchase price.

 

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