Deriving Normalized EBITDA for Your Business

We recently wrote an article about the dangers of failing to properly document business meal and other entertainment expenses. The piece raised quite a few concerns among business owners.

The question we most often heard usually went something like this, “Wait, I thought personal expenses like meals, travel, and entertainment could be normalized…what gives?” Answers to questions such as these, unfortunately, are never straightforward and true standards for deriving normalized EBITDA calculations don’t exist.

First, a quick refresher on EBITDA for anyone who reads it: EBITDA is a basic and widely accepted normalizing adjustment for businesses that tends to serve as a proxy for cash flow when deriving a value for the business. This measure adds expenses from the income statement like interest, corporate income taxes, and depreciation and amortization back into the value of net income to derive the firm’s cash flow.

Normalizing EBITDA before a transaction can help sellers present their business in the best light possible. However, we typically advise clients to be cautious with the level of “owner’s perks,” and corresponding normalizing adjustments, they charge to the business. Below are four of the most common adjustment categories for deriving normalized EBITDA, as well as a few words of caution where appropriate.

1. Non-Recurring Expenses– These are expenses (or benefits) incurred by a business that wouldn’t normally affect the business’ profitability. Adjustments to this category might include (but certainly aren’t limited to) insurance payouts, moving expenses, and losses from discontinuing operations. However, other typical non-recurring expenses like lawsuits may be questioned by a potential acquirer if the business is in an industry known for frivolous lawsuits. In cases such as these, an acquirer may deem lawsuits a normal, and recurring, business expense that needs to be accounted for in the financial statements and should not be normalized.

2. Personal Expenses– A broad category to say the least. Expenses like travel, meals, entertainment, personal insurance policies (e.g., key man), and discretionary bonuses tend to get lumped into this section. Although all of these expenses can be normalized, that doesn’t mean they should be. A good rule of thumb is that expenses not related to business activities shouldn’t be charged to the business.

Here are a few examples:

  • Travel expenses: Recognizing that some may bill travel expenses not associated with the business activities through the business, owners can typically normalize these expenses.
  • Auto leases: These are a typical and acceptable normalizing adjustment, since some executives receive compensation or reimbursement for automobiles. The idea here is that an executive shouldn’t drive a car that would make them embarrassed to meet a client.
  • Meals: In most instances, meals should not be eligible for normalization. However, exceptions do apply. For example, meal expenses related to selling the business, which are non-recurring in nature and are not related to normal business operations, but are related to the ongoing nature of the business can be normalized.
  • Entertainment: Entertainment can be vague, which makes it a popular area for owner perks like sport or event tickets. Like other categories, entertainment should be related to business activities, but when exceptions do take place, they can be normalized.
  • Personal insurance policies, cell phones, and other related perks: These are generally acceptable since they are usually related to the business owner’s involvement in the business, and will not be present following its sale.

3. Excess Family Member Salaries – Similar to personal expenses, some owners provide family members with compensation in excess of what they would pay someone else to do the same job. Considering expenses like these would go away following a sale – presumably the acquirer would only pay fair market wages – excess family member salaries can be normalized.

4. Charitable Contributions – Charitable contributions may be good for your karma and can be normalized in most instances. However, if, for example, a business works with healthcare operations like hospitals, then normalizing charitable contributions to an existing or prospective client’s golf tournament may be considered a sales and marketing expense. Alternatively, charitable contributions not related to the ongoing nature of the business should be normalized.

We hope this brief explanation on normalizing adjustments provides some clarity on what is (and is not) generally accepted as reasonable expense adjustments. Also keep in mind that from an ethical and transactional point of view, improperly charging expenses to the business may save some money now, but it could cost you more in the long run during a sale if an acquirer doesn’t like what they see. We recommend reaching out to your personal accountant or M&A advisor to address any lingering questions or concerns.

This article written by Michael Thomas of Topline Valuation and provided courtesy of www.Axial.net

 

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Why Startups Stall

Have you ever wondered why startup companies stop growing? Sometimes they run out of potential customers to sell to or their product starts losing market share to a competitor, but there is often a more fundamental reason: the founder(s) lose the stomach for it.

When you start a business, the assets you have outside of your business likely exceed those you have in it, because in the early days, your business is worthless. As your company grows, it starts to have value and becomes a more significant part of your wealth—especially if you’re pouring your profits back into funding your growth.

For most business owners, their company is their largest asset.

Eventually, your business may become such a large proportion of your wealth that you realize you are taking a giant risk every day that you decide to hold on to it just a little bit longer.

95% Of His Wealth In One Business

In 2000, Etienne Borgeat and Olivier Letard co-founded PCO innovation, an IT consulting firm. The company took off and, by 2016, PCO had 600 full-time employees and offices around the world.

As the business grew, Borgeat and Letard started to become uneasy about how much of their wealth was tied up in their business. By 2015, the shares Borgeat held in PCO represented 95% of his wealth.

That’s about the point that aerospace giant Boeing came calling. Boeing wanted PCO to take on a very large project and Borgeat and Letard turned down the opportunity reasoning that the project was so large it could risk their entire company if it went wrong. In the early days, the partners would never have turned down a chance to work with Boeing, but the partners had changed.

That’s when Borgeat and Letard realized the time had come to sell. They agreed to an acquisition offer from Accenture of over one times revenue.

The success of your startup is probably driven by your willingness to put all your eggs in one basket. You’re all in. However, at some point, you may find yourself starting to play it safe, which is about the time your business may be better off in someone else’s hands.

 

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What is EBITDA, and Why Do Investors Care About It?

By Karen Sibayan | January 13, 2016 – courtesy of www.axial.net

During negotiations in an M&A deal, buyers and sellers look closely at several factors in order to agree on a price that properly captures a company’s value.

One of the closely examined metrics in this process is EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization.  EBITDA is used as a way to measure company performance. EBITDA indicates whether a business is profitable by revealing the amount of its normal operational earnings.

EBITDA has many uses in addition to the M&A sales process. For traders, analysts, portfolio managers, and others, it is an indicator of whether companies are properly valued. It is also a gauge for lenders to know if companies will be able to pay their future debt obligations. However, while EBITDA provides a valuable snapshot of a point in time in a firm’s cycle, it does not necessarily provide a complete picture of a business’ true value or performance.

What is EBITDA? If you’re considering selling your company, understanding how EBITDA is calculated can help you present your company’s financials in a way that makes your firm’s post-sale cash flow attractive to buyers.

Investors use EBITDA to measure the enterprise value of the company.

“In a sale process, generally what a buyer pays for a company is a multiple of EBITDA,” says James Cassel, chairman of Cassel Salpeter & Co. (an Axial member).

Is EBITDA the Same as Cash Flow?

Many think of EBITDA as synonymous to a company’s cash flow, but is this really the case?

Adams Price, a managing director at The Forbes M&A Group (an Axial member) says that EBITDA serves as “a proxy for pre-tax operational cash flow. It gives a sense of what cash flows might be expected to come out of the business after an M&A transaction.” Since a company’s depreciation, amortization, debt, and tax profile can change as a result of a deal, EBITDA removes those components from the picture. EBITDA is also a more standardized way for buyers to compare companies within their respective sectors.

What EBITDA effectively does, according to Cassel, is take the earnings of a company while not accounting for capital expenditures (capex) and the interest on a company’s debt.

EBITDA removes the factors that distort a company’s profit from the equation. This is why even though EBITDA is not precisely cash flow, it can be considered the best proxy.

Read more about Why EBITDA Is Not Cash Flow here.

How is EBITDA Calculated?

What goes into calculating EBITDA? Kenneth Eades, a professor of business administration at the Darden School of Business, explains how EBITDA is calculated to arrive at this standardized number. “The metric starts with EBIT,” a company’s profit before interest and taxes, “which is a nice number because it indicates how much profit a company produces before it pays debt holders and the government,” Eades says.

After taking EBIT and adding back the depreciation and amortization expenses for the period, we get EBITDA. EBITDA has the benefit of being a number that is not affected by how much debt a company carries. However, “this comparison is ideally used within the same industry because the depreciation and amortization part of EBITDA will differ across industries,” Eades says.

Depreciation expense is created when the cost of a long-term asset is divided and reported as an expense over a period of time. For instance, companies that are in capital intensive industries often have a lot of equipment on the books that creates a significant depreciation expense. When this depreciation expense is added to EBIT, the resulting figure is significantly larger. By contrast, other industries will have little or no depreciation to add back, which means the two figures will be approximately the same value.

While depreciation relates to “real” assets such as equipment, amortization involves adding back expenses tied with intangible assets such as intellectual property or patents. An amortization expense is created when a cost of a patent, for instance, is divided over the length of the patent’s life.

There are differences in companies’ multiples and earnings. When buying the assets of a company, the transactions are mostly on a cash-free and debt-free basis, with the debt being paid off at closing. In terms of cash flow, buyers look at non-cash items such as depreciation. From these, many private equity firms come up with a range of multiples of EBITDA depending on the industry and business characteristics.

 

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Is a Third-Party Sale Really the Best Exit Path?

By John Brown, BEI | July 18, 2017

An increasing number of business owners, many of them aging baby boomers, are seriously considering an exit. According to The BEI 2016 Business Owner Survey Report, 79% are planning to leave their businesses within 10 years.

While owners have many exit options to consider, a third-party sale is among the most commonly anticipated. According to the 2016 survey, 59% of owners are considering a third-party sale (Note: These same owners may also be interested in other options).

Like any other exit option, there are numerous advantages and disadvantages to a third-party sale. For owners considering this option, research and preparation are key. Owners who don’t take the time to figure out which path is best for them waste their own time and effort, along with the time and effort of their M&A advisors, trying to carve a path that may not suit their goals.

Is a third-party sale right for your business? Let’s look at the chief reasons owners tend to select or reject a third-party sale.

Advantages

  • Risk management: When properly planned, third-party sales are the least risky sale/transfer option, because there’s rarely any doubt that the owner will receive the full sale price.
  • Avoiding burnout: Whether owners are tired of working or would rather do something other than work, properly planned third-party sales often allow them to exit sooner than other exit paths.
  • No successor needed: A third-party sale is a viable option for businesses where management or children do not want or are not equipped to run the business without the owner.
  • Financial security: Well-planned third-party sales typically allow owners to exit their businesses with immediate financial security, a luxury rarely afforded to any other exit path, since third-party buyers typically have the cash necessary to pay owners the full sale price on the day of closing. Insiders, such as children, co-owners, or employees, rarely have the cash necessary to close a sale immediately, often requiring more time or bank financing than the owner or bank is willing to allow.

Disadvantages

  • Emotional exhaustion: Third-party sales take time, sometimes more than a year, to complete. Negotiations can spur impatience, leading owners to sell their businesses for less than top dollar or walk away from a deal just to get the process over with.
  • Cost: Good investment bankers/business brokers, CPAs, and deal attorneys cost money, sometimes up to or exceeding 10% of the final sale price. Yet, skimping on these advisors can damage long-term sale prospects and result in a lower purchase price.
  • Time: The time owners spend trying to sell their businesses is time they could be spending increasing business value. Owners who dedicate too little time to increasing (or at least maintaining) their businesses’ value can find themselves receiving a lower offer than they expected or, in the most extreme cases, having a deal withdrawn altogether. A common mistake that owners make as they commit to a third-party sale is killing time waiting for their big payday, assuming that things will simply fall into place because an outside buyer is taking over. This is less common in insider transfers, since good owners typically understand that they still have work to do to build business value to assure that their internal successor can both run the business and pay the full sale price after the owner exits.
  • Market dependence: Today’s M&A market is very robust. But that’s not always the case. It’s much harder to sell a business in a poor economy, as we saw during the Great Recession. Additionally, marketplaces can be brutally harsh to indecisive owners.

In my experience, the best way for owners to know whether a third-party sale is right for them is to assemble a strong exit-planning advisor team. A good advisor will recognize the pros and cons of a third-party sale, and help owners determine whether this option will allow them to leave their businesses when they want, for the money they need, and to the person they choose.

 

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Maximizing Your Business Value Before a Sale

The process of selling a business has become more complex today. Buyers are more cautious and much more rigorous in their due diligence efforts due to the Great Recession. A big reason why a deal fails is that owners do not plan early enough to sell their business. GEM Strategy Management’s experience proves that CEOs and owners should maximize the business value before putting it up for a sale.

Many first time sellers fail to realize that it takes time and careful planning to optimize the business value in order to maximize the sale price. This thus leads to a lower purchase price from a buyer, or worse, no sale at all.

The business landscape changes every three to five years, and your company’s exit plan needs to keep up. Regardless of personal goals, there are some key issues every business owner must address to become transaction ready.

The key to increasing business value is to understand how a potential buyer views your business. That is a two-part job.

  • Obtain an independent, professional valuation from an accredited valuation firm.
  • Engage an objective business adviser to conduct a business audit and assessment to reveal the strengths and weaknesses of the business.

The advisor can help you pinpoint the value drivers. This will ultimately increase your business’s value and sale price from 10% to 35% or more. If the assessment reveals that some of your business drivers are weak, prioritize them and begin correcting or improving them immediately. Once you understand the current value of the business and the value drivers, you can identify tactics to increase its value.

Key business value drivers may include:

  • Sales growth trends
  • Balanced and growing customer mix
  • Strength of sales backlog
  • Strength of the market niche
  • Strong products and services brand
  • Highly skilled, efficient and loyal workforce
  • Solid vendor relationships
  • Product differentiation
  • Product innovation
  • Strong management team that can transition to the new owner, up-to-date technology and modern work-flow systems and processes
  • Robust management information systems, continuous growth in profitability, barriers to competitive entry
  • Strong company culture and loyal customer base. Company culture and existing customer relationships are two critical areas that concern most buyers. If a business is sold, it is important to ensure that employees will embrace the culture of the buyer. Both these buyer concerns can be mitigated if the seller stays on as an employee or consultant for a reasonable period of time.

We suggest business owners to take at least two years to increase and improve the value drivers of a business. During this time, you will be able to correct minor cosmetic issues to help build incremental value.

After two or three years of focusing on value optimization, your business worth should increase in the eyes of potential buyers. Understanding your company’s value and building upon it leads to a larger sale price and maximizes the wealth transfer to the business owner. If the business value process has been carefully carried out, the added value will stand up under the most rigorous buyer due diligence.

Continued owner involvement and the development of a strong management team have become even more important to buyers in today’s M&A environment. As earn-out requirements are commonly integrated into a sale price, performance stipulations tied to profits and revenue are frequently included in the sale contract to obtain the full purchase price.

If you are considering selling your company, act now. You must allow sufficient time to prepare for a transaction to correct any issues and build incremental value. While the market is strong now, strong markets do not last forever. Time is of the essence.

Remember, poor exit planning can erode the value of a lifetime of success.

This article written by Gary Miller GEM Strategy Management, Inc. | November 1, 2017 and provided courtesy of Axial at www.axial.net

 

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Selling Your Business? Here’s What Buyers Look for

By Paris Aden | November 13, 2017

Takeaway: Here are the key areas buyers look at when they are assessing whether or not to acquire your business.

When business owners consider a sale of their company, a common first question is: “How much is my company worth?” The answer is guided by the elements that buyers look for when they assess the value of a business. So, from a buyer’s perspective, what makes a company an attractive acquisition target?

A recent study by Intralinks and the M&A Research Centre at Cass Business School in London provides some answers to this question. Additionally, Paul Eldridge, a partner at Fulcrum Capital Partners, shared insights with us, gleaned from his extensive experience as a private equity investor.

1. Growth

Growth is a leading differentiator for potential buyers. According to the Intralinks study, the three-year compound annual sales growth rate for target companies was, on average, 2.4% higher than that of non-targets.

What if a company has a record of low historic growth, perhaps due to capital constraints, but has exciting future growth opportunities? According to Mr. Eldridge, this type of company may still be an attractive target to a financial buyer if there are “obvious paths to growth and clear execution plans to achieve these growth targets.” This may explain, at least in part, why companies in the bottom decile for growth are actually most likely to be approached as a potential target (see chart below). These companies may also be attractive to strategic (corporate) buyers, if there are cost-reduction and/or revenue synergies to be unlocked.

2. Profitability

Profitability is not to be confused with growth. While some private equity professionals are willing to overlook profitability for solid growth opportunities, historical results suggest that higher profitability is favored by buyers. The Intralinks report found that the profitability of target companies was, on average, 1.2% higher than that of non-targets in the private market.

From a buyer’s perspective, higher profitability reduces the risk of post-transaction operating failure, as well as providing a faster payback period. However, a company struggling with operating losses may be perceived by some buyers as an opportunity waiting to be realized. As Mr. Eldridge told us: “Many private equity investors look for opportunities to add new capabilities to the management team as a path to improving [operating] performance.”

3. Leverage

Private companies with higher leverage are preferred by potential buyers. The chart below illustrates that the average debt/EBITDA ratio for private targets is three times more than non-targets. What is the rationale for this finding? One private equity investor explains it as follows:

“High leverage ratios come at very reasonable valuations…[so] the situation becomes very attractive for us to invest in, provided the business has potential to improve.”

4. Size

Size is a factor for potential buyers, and has becoming increasingly important over the years. Before 2008, the average size difference between target and non-target companies was merely 14%, with size measured in terms of sales. In the years following, the gap widened significantly, and by 2014, target companies were approximately 2.5 times larger than non-targets.

More recently, however, as valuations soar, buyers are setting their sights on smaller companies, which are typically valued at a discount to their larger peers. In fact, predicated on the latest fundraising numbers, a recent Pitchbook article predicts that the next buyout cycle will be “geared towards the middle market, particularly the lower end.”

5. Liquidity

Target companies also tend to have lower liquidity, as measured by the ratio of current assets to current liabilities. Intralinks data indicate that companies in the bottom two deciles in term of liquidity are, on average, 35% more likely to be identified as acquisition targets.

It may go without saying, but we would not recommend pursuing lower liquidity as a strategy to become an attractive target. Lower levels of liquidity are often associated with financial distress, which makes a company more vulnerable as an acquisition target. Under these circumstances, a target with low liquidity is very likely to have a low valuation relative to its peers.

Conclusion

While certain attributes increase the attractiveness of a target, there is no hard and fast rule. Certainly, some buyers look for high sales growth and profitability, as the Intralinks study suggests, but lower performing companies may be attractive as well, albeit at lower valuations. Financial buyers might target these companies if they see an opportunity to create value, improving performance by providing capital or professionalizing management. And strategic (corporate) buyers are likely to target lower performing companies that offer the potential for revenue and cost synergies.

If you are considering a sale of your business, it’s important to understand who your best buyers are. Consider what your company offers a prospective buyer by taking a clear-eyed look at the strengths and weaknesses of your business, and thinking about how different buyers might regard those attributes in their distinct paths to creating value.

 

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How to Estimate the Value of a Private Business

This article provided courtesy of Kevin Bader, MCM Capital Partners

“What is the value of my business?” This is a common question asked by business owners for estate planning or retirement purposes since, in many cases, most of their wealth is tied up in their business. The definitive means of establishing a company’s true value requires soliciting bids from qualified buyers. However, short of putting your company up for sale, this article describes a relatively simple means of approximating the value of a private company.

The total fair market value of a business is called its Enterprise Value, or the sum of a company’s market value inclusive of its debts, minus its cash and cash equivalents. There are various methods to calculate Enterprise Value including, but not limited to, discounted cash flow analysis, using public company comparables or applying recent industry transactions. A valuation approach commonly used by private equity and investment banking professionals, and the one we will discuss herein, applies a multiple (“the Multiple” or “Multiple”) to Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”).

The majority of businesses generating between $10 million and $75 million of annual revenue historically transact for multiples between 5.0x and 8.0x EBITDA. The appropriate Multiple to use in calculating Enterprise Value is dependent on numerous critical factors discussed below.

What Multiple Should I Use?

The appropriate EBITDA Multiple in calculating Enterprise Value is influenced by numerous factors including, but not limited to, level of customer concentration, company and industry growth rates, profit margins, size of the company and strength of the management team. Such factors need to be assessed individually and considered in totality when determining the appropriate EBITDA Multiple. For example, customer concentration (e.g., single customer > 20%) often dictates a lower  EBITDA Multiple. Conversely, companies with little customer concentration participating in attractive end markets such as medical or aerospace, or utilizing unique materials or processes, typically command higher than average Multiples.

What EBITDA Should I Use?

It is common practice to utilize the most recent trailing twelve months EBITDA in calculating Enterprise Value, albeit in certain circumstances it may be more appropriate to  use an average EBITDA of the last 2 or 3 years in the calculation. For example, if the company has experienced a temporary spike or dip in EBITDA due to, e.g., a customer or market issue, an average EBITDA may be more appropriate.

Further, it is common practice to normalize EBITDA, resulting in a term called “Adjusted EBITDA.” Adjustments to EBITDA include non-recurring revenues and expenses (e.g., litigation expenses, changes in accounting methods, certain professional fees, etc.), non-business/personal-related expenses (e.g., car leases not used in business, payments to family members outside the business, country club memberships etc.), facility rent and/or owner compensation above or below fair market value. EBITDA adjustments likely not accepted by the buyer are ineffective marketing campaigns, research and development expenses related to failed product launches or bonuses paid annually but considered “discretionary.”

Understanding the Difference Between Enterprise Value and Shareholders Value

The product of using a multiple of EBITDA results in an estimate of Enterprise Value, not to be confused with Shareholders Value. Since businesses typically transact on a cash-free, debt-free basis, Shareholders Value is calculated as the Enterprise Value (i.e., Multiple x Adjusted EBITDA) plus cash and cash equivalents minus third party debt (e.g. bank debt and capital leases).

The following example merely illustrates how to calculate Enterprise Value using the Multiple of EBITDA method from the foregoing concepts:

Summary 

This article has provided the framework for calculating a company’s estimated Enterprise Value whose true value can only be established by soliciting bids from qualified buyers. However, it is possible to provide a reasonably close approximation of Enterprise Value with the help of a qualified professional who can assist in identifying and quantifying critical valuation factors.

The next article explores our view on critical factors affecting Enterprise Value including:

  • EBITDA Size
  • Revenue Trends
  • Profit Margins
  • Customer Concentration
  • Industry Growth Rate
  • Strength & Depth of the Management Team
  • Competitive Advantages

 

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5 Lessons From Home Depot’s Acquisition of Blinds.com

Jay Steinfeld built Blinds.com into a $100 million e-tailer before selling out to Home Depot. Here are five things that made it a spectacular exit.

Win The Make vs. Buy Battle

Companies like Home Depot have a “make or buy” decision when they see a competitor winning market share. They can opt to buy the competitor or choose to simply re-create what they have built.

An acquirer will likely opt to buy your company if you are so dominant in your niche that recreating what you have built would take too long and cost more than acquiring it from you.

Blinds.com got acquired, in part, because they were a big fish in a small pond. At more than $100 million in revenue, they were the largest online retailer of blinds in America by a long shot. Even though Home Depot has close to $90 billion in sales, Blinds.com were outperforming them in their tiny niche and that made Blinds.com irresistible to Home Depot.

Run It Like It’s Public

At the time of the Home Depot acquisition, Blinds.com had 175 employees, yet Steinfeld had been running the company as if it were public for years. He had put together a top-drawer management team and taken the unusual step of assembling an outside board of directors. He had quarterly board meetings with formal presentation decks, and Steinfeld hired a Big Four firm to complete a full audit of his financials each year.

Steinfeld credits this rigorous approach to running a relatively small company as a major reason Home Depot was interested in Blinds.com and able to close on the acquisition so quickly.

Keep Most Of The Equity

Steinfeld invested $3,000 of his own money into a basic online presence for his blinds store back in 1993 and grew Blinds.com to more than $100 million in sales without diluting himself by taking three or four rounds of institutional investment, as would be typical of an internet start-up. Steinfeld took a small investment from friends and family and used bank debt to help him buy distressed companies for pennies on the dollar. It wasn’t until 2012—almost 20 years after starting the business—that he accepted his first round of “professional” money from a private equity firm who wanted to invest more, but Steinfeld refused, only taking enough to buy out a few of his original investors and pay off some debt.

Keep Investors Aligned

One of the reasons Steinfeld accepted an investment from a private equity group was that he had become misaligned with two of his original investors. The investors saw the success of Blinds.com and wanted Steinfeld to start declaring regular dividends. Steinfeld, by contrast, was focused on building a growth company and needed the cash to fuel his 25% per year growth. After a while, his investor’s expectations got so far out of whack that Steinfeld opted to buy them out.

Share The Love

One of Steinfeld’s best memories is the day he told his employees Home Depot had acquired Blinds.com. Steinfeld had made sure every one of his 175 people had Blinds.com stock options and so stood to gain financially from the sale. Steinfeld went further and gave each employee $2,000 of his own money to start an investment account as a personal thank you for all they had done.

 

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Is a Private Equity Sale Right for Your Business?

By Jane Johnson Business Transition Academy | September 12, 2017

Private equity firm (PEF) recapitalization has become one of the top reasons that businesses valued at $2-50 million are going to market, according to the Market Pulse Report, which is published quarterly by the International Business Brokers Association (IBBA), M&A Source, and the Pepperdine Private Capital Markets Project.

Private equity is definitely an attractive possibility for some owners who are looking to transition out of their businesses. With the PEF injection of capital into the business, the owner cashes in some of his or her equity (usually a majority stake) but also maintains some ownership. The owner usually stays on to help grow the business under the supervision of the PEF and bolstered by its financial and business resources. However, as with any sale transaction, there are a lot of complexities that owners need to understand before exploring this business transition option.

Understanding Recapitalization

Financial buyers such as private equity firms are looking to invest in businesses and get a handsome return. Their goal is to scale the company, increase its value over the next three to five years, and then sell it in the future at a much higher value. If things go well, this two-step process can result in a second payday for the owner when the business is sold again.

Financial buyers typically invest in companies that have a capable management team, a solid team of employees, and high growth potential. A private equity sale almost always involves the owner remaining involved, generally in an operational capacity. This type of sale can be beneficial for owners because it reduces their risk and allows them to sell a portion of the business, but still retain some equity that may grow in value.

Who Are Good Candidates for PEF Investment?

This type of transition isn’t for everyone, and there are a few things you need to consider:

  • It may be difficult to find a PEF with the right resources and expertise to help you grow the business.
  • You have to be ready to work for someone else and be accountable to them for at least one to three years.
  • You and your team have to be fully committed to operating and growing the business for the next several years.

A 2014 article “Equity-worthiness and equity-willingness: Key factors in private equity deals,” published by the Kelley School of Business, Indiana University, reports that “less than 3% of pre-negotiations between privately held companies and PEFs lead to a closed deal. This means that the process is exacting; roughly 97% of negotiations initiated by PEFs collapse.” It is important for business owners to understand what makes a company an attractive target for private equity firms and what goes into making a deal successful.

What Private Equity Firms are Looking For

PEFs are looking for good investment opportunities that are “equity-worthy” and will produce solid returns. They expect the value of their stake in a company to increase significantly as a result of their efforts to increase capacity and revenue, provide complementary resources and capabilities, and improve corporate governance and processes.

Increasing Your Business’s Equity-Worthiness

PEF investors are looking for future return on investment and growth potential, so remember to emphasize this rather than dwelling on past performance. Growth opportunities, reputation, and industry leadership are some of the many qualities investors value. Other ways to increase your business’s equity-worthiness include:

  • Documenting improvements that can be made with new capital
  • Providing clean financials
  • Reducing the risks in your business
  • Understanding your competition
  • Setting specific goals to improve your business and drive to achieve them

As you can see, the process will likely be time-consuming, intensive, and not of interest to an owner who wants to walk away from his or her business.

Determining if a PEF Sale Is Right for You

There’s no guarantee that there will be a second pay day for the owner as the result of a PEF sale. If it’s something you’re considering, you will need to do your own due diligence and look for PEFs that have a track record of success with similar companies. And, because you’ll most likely be heavily involved in day-to-day operations for some time, you want to make sure that your vision and goals for the company are closely aligned with those of the PEF. Start the process well in advance to achieve the best outcome.

Before going down this path, we suggest that owners:

  • Develop a Business Ownership Transition Planthat allows you to determine which transition options are right for you
  • Understand prospective PEF buyers and what they are looking for
  • Work with business advisors who can assist you with improving your business and presenting it to PEF investors
  • Determine what is attractive about your business in light of PEF buyers’ unique considerations, and position your company in the most beneficial way

If you are thinking about selling and realize you need outside capital and expertise to significantly grow the value of your business, you may want to consider a private equity investment. However, we encourage owners to seek independent and objective advice before making any decisions. There may be other ownership transition strategies that will enable you to achieve your goals. You want to be sure you consider all of them before taking this big step.

 

Is your business creating maximum value?

Complete the “Value Builder” questionnaire today in just 13 minutes and we’ll send you a 27-page custom report assessing how well your business is positioned for selling. Take the test now:

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5 Reasons Why Now Might Be The Right Time To Sell

Are you trying to time the sale of your business so that you exit when both your business and the economy are peaking?

While your objective to build your company’s value is admirable, here are five reasons why you may want to sell sooner than you might think:

1. You May Be Choking Your Business

When you start your business, you have nothing to lose, so you risk it all on your idea. But as you grow, you naturally become more conservative, because your business actually becomes worth something. For many of us, our company is our largest asset, so the idea of losing it on a new growth idea becomes less attractive. We become more conservative and hinder our company’s growth.

2. Money Is Cheap

We’re coming out of a period of ultra-low interest rates. Financial buyers will likely borrow money to buy your business so—at the risk of over simplifying a lot of MBA math—the less it costs them to borrow, the more they will spend to buy your business.

3. Timing Your Sale Is A Fool’s Errand

The costs of most financial assets are correlated, which is to say that the value of your private business, real estate and a Fortune 500 company’s stock all move in roughly the same direction. They all laid an egg in 2009 and now they are all booming. The problem is, you’ll have to do something with the money you make from the sale of your company, which means you will likely buy into a new asset class at the same frothy valuation as you are exiting at.

4. Cybercrime

If you have moved your customer data into the cloud, it is only a matter of time before you become the target of cybercrime. Randy Ambrosie, the former CEO of 3Macs, a Montreal-based investment company that manages $6 billion for wealthy Canadian families decided to sell in part because he feared a cyber attack. Ambrosie and his partners realized they had been under-investing in technology for years, at a time when cybercrime was becoming more prevalent in the financial services space. Ambrosie decided to sell his firm to Raymond James because he realized the cost for staying ahead of hackers was becoming too much to bear.

5. There Is No Corporate Ladder

In most occupations, the ambitious must climb the ladder. Aspiring CEOs must methodically move up, stacking one job on the next until they are ready for the top post. They have to put in the time, play the right politics and succeed at each new assignment to be considered for the next rung.

By choosing a career as an entrepreneur, you get to skip the ladder entirely. You can start a business, sell it, take a sabbatical and start another business and nobody will miss you on the ladder. Your second (or third) business is likely to be more successful than your first, so the sooner you sell your existing business, the sooner you get to take a break and then start working on your next.

It can be tempting to want to time the sale of your business so that the economy and your company are peeking, but in reality, it may be better to sell sooner rather than later.

 

Is your business creating maximum value?

Complete the “Value Builder” questionnaire today in just 13 minutes and we’ll send you a 27-page custom report assessing how well your business is positioned for selling. Take the test now:

Sellability Score