Positioning Your Company for Sale
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by H. Andrew Connolly, CPA
People who run their business with a ‘for sale’ attitude will boost the company’s value (even if it isn’t actually for sale). If the burst of mergers and acquisitions in recent years has been eye-popping, M&A in the early 2000′s should be astounding.
If the burst of mergers and acquisitions in recent years has been eye-popping, M&A in the early 2000′s should be astounding.
Imagine. With the number of info-tech start-ups surging in the late 1990′s, most of them will be sold in the next few years.
Like all new industries in a free market economy, today’s fragmented e-business industry will eventually mature. Its growth rates (and stock prices) will dim. The industry will consolidate. Market leaders will make acquisitions to boost profit margins through economies of scale and scope, or by innovation, or both.
To these e-entrepreneurs (and their financial backers), selling a company or taking it public is precisely what they want. The sooner the better.
Anyone who’s sunk capital and human toil into an enterprise in return for equity owns nothing of real value – that is, until the stock is sold.
But what about the owners of traditional brick-and-mortar companies who have nurtured their enterprise’s growth? To many of them, their business has been their lifeblood. They may feel that relinquishing control of it is akin to death.
Nevertheless, for both groups, getting the best price for their business is paramount. And the best way to get the highest price is to manage the company as if it were for sale.
Even if you have no plans to sell, you’ll run a more efficient and financially valuable enterprise if you pretend you do. I call it a “drive-toward-value” mentality.
When you constantly drive toward value, the results are in plain view to owners, managers, investors, creditors, advisors, and prospective buyers. The evidence is on the books and the bottom line and in tax filings, inventory, equipment, the management team, and succession planning. Even the company’s culture reveals efficiency or not.
This is true of all businesses, private or public. But the difference is that managements of publicly owned firms are under constant pressure to boost value. Managements of private companies aren’t, so they must be sufficiently self-disciplined to push hard toward creating value. A financial manager or CFO of a private firm who’s forward thinking and driven to create value will be tremendously respected and appreciated by the owner.
Whether a sale is in the imminent future or not, here are some fundamentals you’ll need to tell the owner about keeping the company tuned up, its engine humming, profits proliferating.
Have a Business Plan. A business plan is a map for creating value. It identifies your market position, sets goals, details how they’re being achieved, guides operations, and measures progress. When a company goes on the block, the business plan introduces it to prospects.
Document All Profits. The more profitable the business, the higher the selling price, the faster it’ll be sold. But profits must be documented. Most buyers won’t recognize undocumented profits. Nor will a buyer’s lender. In fact, bank lenders won’t even finance a transaction than doesn’t have a strong and well-documented cash flow. With at least some debt a part of most transactions, documented profits are crucial.
Keep and Record all Perquisites. Private-company owner perks – a car, travel and entertainment, medical and life insurance, retirement plans – should be well documented. As legitimate expensed items, they lower income. But they won’t necessarily exist, or they’ll be accounted for differently, under another ownership structure. So prospective buyers routinely add these costs back to cash flow from operations.
Clean Up the Warehouse. Obsolete inventory, machinery, and equipment tends to accumulate. Some owners are loath to part with it. They hope to unload it for something more than fire sale prices. Forget it. Buyers don’t want and won’t pay for outdated inventory or equipment. They want a “clean” opportunity with truly productive assets that will provide the maximum return on investment.
Make Sure You’re Environmentally Compliant. Routinely inspect and test property to ensure the business conforms to regulatory codes. Most purchase agreements contain language making the transaction contingent on meeting regulatory requirements.
Delegate Responsibility. Developing people in key management and operating roles enhances a company’s desirability. It reduces dependence on the owner, and it allows a new owner to learn the business while the company’s operations are run by existing managers.
WHAT’S THE VALUE?
With the fundamentals in place and the business running smoothly and prepared to be sold, you’re probably wondering what it’s worth.
Most of the techniques used to value public companies are also used to value private firms. But public companies have a built-in valuation: the stock market. An information-efficient market values the company whenever trading occurs. Stock market price multiples or ratios, such a s price/earnings, price/sales, price/cash, and price/assets, help create a framework for valuing a company. (The numerator is the company’s stock price, and the denominators can be found in the company’s annual report.)
But ratios only begin to value a company properly. Stock prices can be artificially inflated or deflated, and accounting numbers are methodological, based on GAAP’s accrual, so they aren’t necessarily “real.”
The key determinant of a company’s value is the discounted cash flow (DCF) technique. This is a forecast of future free cash flows from operations discounted to the present at the firm’s cost of capital. Free cash flow is equal to after-tax operating earnings plus noncash charges less investments in working capital; property, plant, and equipment; and other assets.
Future operating cash flows are calculated according to an annual rate of growth. How fast they grow is an amalgam of the company’s historical operating growth rate and competitors’ growth rates plus specific improvements to the business that, if made, will increase future cash from operations.
Although DCF is the most widely used and reliable method of valuation, the future is ultimately unpredictable. Certainly, something as capricious as product and service markets is tricky to predict. To help make the DCF calculation more accurate, different probabilities are assigned to the growth rate, and this exercise produces a range of values with which to work.
To test your valuation numbers, match them against a typical buyer’s concerns – mainly, will the company as a going concern provide a satisfactory return on investment over the long run?
Over the short term, a buyer wants to know three main things:
Debt. Will the income from the business sufficiently cover the debt service required to finance the company? (The higher the monthly cash flow as a percent of debt the better.)
Owner’s Compensation. Will the new owner be reasonably compensated for his or her role in the business?
Replacement of Assets. Since almost all businesses have fixed assets that wear out and must be replaced over time, will the business’s income be adequate to replace assets as needed?
If these typical buyer’s criteria are met, then it’s likely the business is properly and fairly priced. If it is, the offering will generate interest and will usually sell at the offering price quickly, in nine to 18 months.
WHAT FINANCING DO YOU NEED?
The financing of the transaction is often as important as the price. It usually consists of three components: buyer’s equity, bank loan, and seller’s financing.
The buyer’s equity investment should be significant; 25% to 35% of the sales price is a reasonable range. The bank loan portion of the financing should correspond directly to the value of the assets plus any other collateral that may be offered. Usually it’s 50% to 65% of the total financing. And seller financing – which is typical in most small-business deals today – may be in the form of a fixed note, a consulting or noncompete agreement, or some type of payout based on performance.
Overall equity, risk, and tax considerations influence the terms of a deal. So does the lending environment. And the profitability and desirability of the business weigh heavily on the terms of sale.
THE SELLING PROCESS
When you’re ready, or the business is, selling it is a time-consuming and complex process. But it can be easier and more successful if you engage a qualified advisor, such as a business broker or merger and acquisition specialist.
The independent advisor values and prices the business. He or she establishes terms, prepares an accurate prospectus, markets the business broadly to qualified prospective buyers, and then carefully screens them. The advisor also negotiates the transaction, assists in obtaining financing, and guides the transaction through closing.
In addition to the broker, the owner needs a competent accountant to help perform the financial analysis and structure the transaction to minimize tax obligations. As the CFO or financial manager, you’ll obviously be in charge here. And you’ll need an attorney to draft the appropriate documents and protect the owner’s legal interests.
Brokers are usually compensated at a percentage of the sales price, commonly ranging from 5% to 12%. Often, as the sales price increases, the commission percentage decreases. While most compensation is paid when the transaction is complete, the broker may charge a retainer or monthly fee from the outset. Also, some brokers may price the valuation separately.
There are many brokerage companies as well as merger and acquisition firms to choose from. Generally, business brokers and M&A specialists have many of the same skills. But M&A firms will charge you more for their army of analysts and the prestige, credibility, and network of contacts they devote to marketing larger companies. Choose one that has the ability to close transactions. Evaluate whether the firm has an established track record. Ask whether its principals and staff have the expertise to understand your business and represent the company well. Similarly, find out whether the firm has successfully sold a business such as yours. Find out whether the firm is a member in good standing with and subscribes to a code of ethics of a professional association such as the International Business Broker Association.
Finally, your personal relationship with the firm and its people is important. You should feel confident that you can establish a close working relationship with them and that the company’s and the owner’s interests will be represented properly throughout the process.
Selling a business is the culmination of years of hard work. Whether it’s now – or never – preparing the company for sale is one of your best managerial moves.
H. Andrew Connolly, CPA, is a management consultant who specializes in finance and corporate strategy. He has been an advisor to and involved in the sale of small and midsized companies throughout the northeastern U.S. and Atlantic Canada. Connolly was also a CFO and CEO of four manufacturing companies ranging in size from $5 million to $70 million in revenues. You can reach him at (603) 627-7887 or firstname.lastname@example.org. The article was originally published in Strategic Finance magazine and is reprinted here with permission from the author.