Valuing and Selling Your Business: A Quick Guide to Cashing In (2014)
Chapter 4. Growing Your Value
Becoming More Attractive
Tim is a single young man in his early 20s. He wants to get married, have three kids, and a house in the country with a couple of dogs. It’s a great plan, but the only thing missing is a wife. At this point, Tim doesn’t have a girlfriend or any prospects. Tim asked a couple of his good friends about the best way to find a girlfriend that could become his spouse. Should he use an online dating service? Can they introduce him to someone?
Will, Tim’s best friend from childhood, calls him up and says that they need to talk. Will and Tim meet up at the local pub, and Will orders a couple of stiff drinks. He looks very uncomfortable and tells Tim that he has something very personal to tell him. He says, “My friend, before you start looking for a spouse you need to make yourself more attractive. You dress like a slob and don’t brush your teeth or shower. You live in your parent’s basement and drive a rusted-out car without a heater or air conditioner. You don’t have a job or any prospects for a good job. And finally, when you meet a girl you only talk about yourself while looking at your shoes.”
After what seems like an eternity to Will, Tim responds and says, “Thank you for telling me this. It took a great deal of courage to say these things to me, and I know you said it because you care about me.” Will is now more at ease, and they continue their discussion. At some point, Tim says that over the next couple of years, he is not going to look for a girlfriend but instead concentrate on making himself a better “catch.” They devise a plan that starts with Tim brushing his teeth and taking a shower.
You know by now that this is not a book about dating and personal improvement. The point of this story is that before you go out and look for a possible suitor for your business, you need to make it as attractive as possible. Even if you don’t intend to sell your business soon, it is important that you consider ways to make your business more attractive and healthy. By doing so, you will more enjoyment in running your business, make more money, and make it easier to sell your business when you are ready to cash in.
Having the Mindset to Increase the Business Value
It all starts with a “mindset.” Do you treat your business “like an investment” or as a vehicle to support your lifestyle? Business owners who have written goals and plans to increase their value will be more successful in increasing the value of their business than those who simply hope the value will increase without having any concrete plans on how to make that happen.
Once you understand what your business is worth, the next step is to set goals on where you want the value to be in the future. How much do you want your business to increase in value one year from now? Where do you want the value to be when you sell the business? Not many business owners take the time to set specific goals for their business value as well as written strategies to achieve those goals. The few that I’ve witnessed doing this have been much more successful in growing the value of their business than the typical business owner.
Important You should include your valuation goals and the strategies to achieve these goals as part of your strategic plan and succession plan.
If you have no intention of selling your business, should you set goals and develop plans to increase its value? Absolutely! Setting a course to increase your business value today will provide you with many important benefits besides a higher selling price. The following are three key areas to focus on to increase your business value (Figure 4-1):
Figure 4-1. Focus on these three areas to increase your business value
How would you feel about your business if it had a better cash flow, fewer risks, and a higher growth rate? I bet it would be much easier to get out of bed in the mornings. If you can accomplish these three items, there will be a number of benefits besides a higher selling price:
· More cash available to distribute to yourself or to reinvest in your business
· Sleeping better at night with less stress and worry after reducing business risk
· A healthier business that will allow you to withstand a downturn in your industry or the economy
· Being able to react quickly to an selling opportunity that may present itself
· A more exciting and pleasant work atmosphere
· Increasing your retirement contributions, which will allow you to have greater flexibility in choosing your exit strategy
There are additional benefits as well, but it all starts with your decision to increase the value of your business and develop a plan to make your business more attractive to others.
If your business is the Brad Pitt or Angelina Jolie of the business world, you will have no problems obtaining suitors. You can skip the rest of this chapter. If not, please read on to learn about strategies to make your business more attractive. Besides increasing your cash flow, reducing your business risks, and developing a growth plan, it is important that your business does not have any hygiene issues that will turn off any potential buyers. Also, your business will be more attractive to suitors if it has a professional and sophisticated look to it. The remainder of this chapter is focused on making your business more valuable and attractive through the following strategies:
· Improving your business hygiene
· Increasing your sustainable cash flow
· Reducing your business risks
· Developing a growth plan
· Professionalizing your business
The best way to understand how these areas will impact your business value is to walk through a scenario. We will see how the value of Drew’s business, Sensational Snacks, Inc., grows as we implement these strategies. You will be amazed by how much Drew’s business increases in value without a major overhaul of the business.
Drew’s Sensational Snacks
Drew is the 100% owner of Sensational Snacks, Inc., which is a manufacturer of potato chips and pretzels. The business has been in operation for 25 years, and Drew is the 60-year-old founder. He has a son and a daughter in the business and has not fully developed his exit strategy and succession plan. He wants to pass down the business to his kids, but he does not have enough money saved up to retire in the near future. Drew works 60 hours a week and is a control freak. He is the CEO and not a very good delegator. His daughter is in charge of accounting, and his son leads the purchasing department. The other members of the management team include the plant manager who has been with the business for 20 years and a sales manager who has worked for the company for 6 years. The following are some additional facts about the business:
· The business has one large customer: a supermarket chain that comprises 30% of revenues. The next two biggest customers account for 12% and 8% of revenues, respectively. Drew’s top three customers are 50% of the total revenues.
· The historical sales and profit levels have been inconsistent. In the past five years, Drew had one great year, two decent years, and two bad years. His profits depend on potato prices, competitors’ pricing actions, and the top three customers’ buying habits.
· The average annual growth rate has been 2% over the past five years. The industry forecasts 3.5% growth over the next five years.
· Drew takes out $220,000 a year in wages and has full benefits. In addition, the business pays for all of his family vehicle expenses and an annual “business trip” for the family. These additional benefits are in the $30,000 range annually.
· Drew is unsure about his exit strategy. He would like to see the business continue in the family, but he cannot afford to gift it to his children and they don’t have the resources to buy it. Also, he can’t decide which child would be the best leader.
· Outside of the business, Drew has a net worth of $1.2 million, with $700,000 in liquid investments (savings, stocks, bonds, and mutual funds) and $500,000 in real estate. His investment advisor has told him that he needs $3 million in liquid investments to retire at the lifestyle he wants at age 65.
Here is a summary of last year’s income statement. These results are very similar to the average of the past five years. Some years have been better, and some have been worse. Drew believes that his results over the next few years will be similar.
Based on these facts, what is Sensational Snacks’ enterprise value on a fair market basis? Can Drew sell his business and have a comfortable retirement? Remember, “fair market value” basis does not factor in any synergistic benefits. For this example, let’s assume that the sustainable cash flow is similar to the after-tax net income level. Based on this fact pattern, a buyer of Sensational Snacks can expect to put $325,000 in his pockets on an annual basis.
What is the required to entice someone to make an investment in Sensational Snacks? The risk concerns that a buyer would have include the following:
· The top three customers make up 50% of the revenues and the largest customer is 30% of revenues. The loss of the largest customer would be devastating.
· The business is very dependent on Drew. If something happened to him, business operations would suffer. There is no succession plan in place, and no one is specified to be the leader after Drew leaves. Outside of his son and daughter, there are only two individuals who are part of the management team.
· The historical earnings have been inconsistent. This is due to the volatility of potato prices and the fact that, at times, large competitors deeply discount their prices, hurting Drew’s sales.
Based on these three major risk factors, it is determined that a 25% rate of return is required to entice an investor. The following is the calculated enterprise value:
At this point in time, Drew could sell the business operations for $1.3 million For the purpose of this example, let’s assume that Sensational Snacks does not have any nonoperating assets or any liabilities that Drew will have to pay off when the business is sold. Therefore, the equity value equals the enterprise value. Let’s also assume that the tax and transaction cost related to the transaction is $400,000. Based on this fact pattern, the amount that Drew can invest or spend after the sale of his business is $900,000.
After a sale, Drew would have $1.6 million in liquid assets and $500,000 of real estate. His net worth is $2.1 million but he would no longer have his $220,000 salary and the related benefits. How long will it be before Drew runs out of money in retirement? Based on his lifestyle, he will run out of money before he turns 75. He is frustrated because he feels like he will have to work another 10 years to meet his financial goals. What can Drew do to achieve his retirement dreams?
Improving Your Business Hygiene
In our first illustration, there were a couple of easy first steps that Tim could take in order to become more attractive to the opposite sex: brush his teeth and take a shower. Without these two actions, Tim would never get any dates, no matter how successful and loving he was.
This concept also applies to your business. There are major turnoffs to buyers that are not hard to correct but can make a big difference in attracting suitors. In addition, there are a couple of situations that are such major turnoffs that the business owner must resolve them before placing the business on the market.
Let’s stick with the dating analogy. In today’s world, Internet dating is very popular. It is unfortunate, but true, that someone on the other side of a computer will size you up in minutes based on your online profile. Your online profile is your first impression to a sea of potential suitors.
First impressions are important. You don’t get a date with a bad first impression. For most potential buyers of your business, their first impression of your business is your web site. Remember the last time you searched the Web for a service (house or carpet cleaning, accountant, home improvement, and so on)? I am sure that some web sites were inviting and you wanted to know more about the service, while others were uninspiring and you immediately clicked to the next site.
It is important that you have a web site that will not turn off a buyer. It would be better not to have one than to have a web site that looks like you spent 30 minutes developing it from a 1995 template. Your web site will be the first impression that potential buyers will have about your business. Make sure that it is inviting enough for them to want to pursue you in person.
The second hygiene issue is the look and feel of your business facility. When you are looking to buy a house, “curb appeal” is important. When I am in the market for a house, I know within seconds whether I have interest or not due to “curb appeal.” Like a house that is for sale, your business facility projects an image to potential buyers. When potential buyers arrive in person for the first time, does your facility attract them or repel them? How do they feel about your business when they leave? Was it chaotic and sloppy or professional and exciting? Just like a first date, buyers will leave their initial meeting with a specific impression, and it may not accurately reflect the true nature of your business. Before putting your business on the market and having buyers visit your facility, make sure that your facility is clean and organized. Add a fresh coat of paint and new carpet, eliminate the clutter in the office, and get rid of any potential offensive images on your walls.
Consideration Will having a better web site and a nice-looking and well-organized facility increase the dollars that you get in a sale? Maybe not, but it will increase the number of suitors you will have.
After potential buyers get past their first impression of your web site and facility, there are other very significant hygiene issues that will have an impact on their desire to pursue your business further. How well your business performs back office tasks (billing, collections, and paying vendors) is very important to buyers. After they buy your business, they want to focus on selling and making a product. They don’t want to waste time and energy on the back office issues. The more confidence that buyers have in the efficiency of your back office, the more attractive your business will be to them.
There are a few situations that will make it very difficult for you to sell your business or force you to sell at a fire-sale price. These issues must be resolved before placing your business on the market, and they include a major lawsuit, negative publicity that has been broadcast on the internet or in the media, the loss of a major customer, and defective product and warranty issues. Once you’ve taken care of those issues, allow some time to elapse from the event before putting your business on the market.
Even if you are not selling your business, addressing these basic business hygiene issues can improve your business’s cash flow. An inviting web site will drive business. Cleaning up the facility may allow for productivity gains. A functional back office will allow you to bill and collect receivables quicker. These are important areas to address. However, the real increase in your business value comes from increasing your future cash flows and reducing business risks.
Increasing Your Sustainable Cash Flows
Investors buy future cash flow. They look at your business like it is a cash machine. Any actions taken that increase the future cash flow of your business will increase its value. Investors love to buy cash flow that is repeatable and can grow in the future. There is a three-pronged approach to increasing your sustainable cash flow:
· Increase your revenues.
· Improve your gross margin percentage.
· Lower your operating expenses.
We will discuss strategies on how to increase your revenues and grow your business later in this chapter (see the section on “Developing a Growth Plan”). For now, I will focus on the last two items.
Improve Your Gross Margin Percentage
The most important item on your financial statements to a potential buyer is your gross margin amount and percentage. Gross margin (or gross profit) is the difference between the product selling price and the cost to produce or acquire a product. It measures what is available to you to cover your operating costs and provides you with profits after factoring the costs to make a product. Operating costs include expenses like office wages, rent, advertising, and professional fees. The gross margin percentage is simply the gross margin divided by revenues.
The following is the gross margin level amount and percentage for Sensational Snacks:
The cost of goods sold for Sensational Snacks includes the raw materials (potatoes, wheat, cooking oil, and salt) as well as factory wages, facility expenses, equipment costs, and delivery expenses. Determining the cost of goods sold is more difficult for a manufacturer than for a retailer. For a retailer, it is simply the cost to buy the product that is sold to the customer. It is important that you compare your gross margin percentage to others in your industry to see how you stack up. (The best source to find this information is a trade association for your industry.) Also, your gross margin percentage trend is critical when valuing a business. A rising gross margin percentage makes your business more valuable.
There are two ways that you can increase your gross margin percentage. You can either raise the selling price of your products or lower the cost associated with making your products (material and labor):
· Raise the selling price: In today’s competitive market, it is difficult to raise prices. Price increases across the board do not work. Instead, you should analyze each product or service offered and selectively raise prices on items where demand is strong and competition is weak. Also, you can raise your price if you can increase your customers’ perception regarding the value of the product or service that you offer. If you can demonstrate to your customers that your products and services are superior to those of your competitors, then you can charge a premium. Starbucks has been very successful with this strategy. This is how they get customers to pay double for what others charge for a cup of coffee.
· Lower the cost of goods sold: You want to make sure that you are producing or acquiring your products in the most efficient way possible. By lowering your material waste and labor costs, your gross margin percentage will increase. I have seen amazing results from clients who have adopted a Six Sigma or lean approach to making a product or delivering a service. From this, they gained significant efficiencies and have seen their gross margin levels increase. In addition to becoming more efficient, you should carefully study how you purchase raw materials. Lowering the prices you pay for raw material costs will increase your gross margin percentage. You can do this by comparison pricing between vendors, seeking volume discounts, and, in some industries, by using hedging strategies.
You will see increases in your gross margin percentage if you selectively increase prices and become more efficient in delivering your product or service to your customers. A small change in your gross margin percentage will have a large impact on value.
Let’s look at how a change in the gross margin impacts Sensational Snacks’ value. Drew slightly raises the prices on two of his most popular snack lines. He was also able to reduce product waste and increase his production line efficiency after hiring a lean Six Sigma consultant. Sensational Snacks’ gross margin percentage has increased from 30% to 32.5%. After these changes, notice the impact on Sensational Snacks’ net income:
Drew’s gross margin percentage increased from 30% to 32.5% and the gross margin level increased from $1.8 million to $1.95 million. How does this impact his value? Here is the new enterprise value after this change:
With only an increase of 2.5% in the gross margin percentage, the value of Sensational Snacks increased from $1.3 million to $1.69 million. It was well worth Drew’s efforts to focus on improving his gross margin percentage.
Lower Your Operating Expenses
Operating expenses are the costs to operate a business that are not related to producing a product or delivering a service. These costs include office rent, administrative wages, advertising, telephone, utilities, entertainment, and professional fees. Sometimes these costs are called general and administrative expenses or overhead.
It is easier to identify potential cost savings in operating expenses than it is in the cost of goods sold. Looking for the cheapest phone service or coming up with strategies to lower travel costs is much easier than gaining efficiencies at producing a product or delivering a service. Most businesses run a fairly tight ship when it comes to operating expenses. During the recent downturn in the economy, most business owners had to lower their operating expenses in order to survive.
Business owners can become too focused on lowering their operating expenses and hurt their business value down the road. Some operating expenses are necessary to keep you in business (rent, telephone, and office wages), and you should make sure there is no waste in these items. However, there are expenditures that you make that can improve your business value. It makes sense to spend $20,000 on a lean Six Sigma consultant if it will result in a $400,000 increase in the value of your business. Certain expenditures will provide you with a great return on investment including hiring consultants to improve efficiency, preparing annual valuations, and developing a strategic plan. Spend your operating expenses wisely. Cut the expenses that are not needed to keep you in business and that do not increase your business value.
One of the biggest mistakes business owners make is having the business pay for personal expenses. Vacations, vehicle expenses, and relatives on the payroll who do not contribute may provide you with some tax savings, but they also lower your business value. If you are planning on selling during the next few years, I suggest that you forgo those personal perks that you have your business pay. That “business trip” that really was a $30,000 vacation may cost you $120,000 in value. Remember that the price you receive in a sale is a multiple of your cash flow. You may be able to explain to the buyer that the $30,000 business trip was not necessary and should be added back to earnings. Some buyers may agree with you, while others will not. Why risk it? Eliminate personal expenses that are not typical in your business.
Important Do not treat your business like your personal “piggy bank.” Avoid having the business pay for your nonbusiness personal expenses. Not only will you sleep better knowing that you are in compliance with the tax law, you will receive more cash proceeds when you sell your business.
Going back to our example, let’s see how lowering operating expenses will impact the value of Drew’s company. He has decided that the company will no longer have the business pay for all of his vehicles and vacations. In addition, he determined that he was overstaffed by one administrative person and proceeded to eliminate that position. With those two steps, he was able to reduce his operating expenses by $100,000. The following is his revised income statement after improving his gross margin percentage and reducing his operating expenses:
The combination of increased gross margin and reduction of operating expenses has increased his net income from $325,000 to $487,000. Here is the new enterprise value after these two changes:
Drew’s value just keeps growing. The increase in value due to the increase in the gross margin percentage and lowering operating expenses is $648,000. Certainly it was worth Drew’s time and effort to devise strategies to increase his gross margin percentage and lower his operating expenses.
Reducing Your Business Risks
As stated earlier, there is an inverse relationship between your business value and the required rate of return needed to entice an investor to buy your business. The higher rate of return required, the lower the business value. I explained in the previous chapter that the required rate of return is a function of business risk. Business owners must understand this concept. Reducing business risk is the area where I believe business owners have the most control in affecting value. Earlier, I discussed strategies to increase your cash flow; however, the marketplace may prevent a price increase or it may not be possible to reduce your costs to make a product. Business owners can reduce business risk with the proper focus and strategies.
Why does risk lower value? It is because risk causes uncertainty about the future cash flows of the business. Once you truly understand how specific risk factors impact your value, you will be motivated to establish a plan of action to reduce your business risks. The steps involved in reducing your business risks are as follows:
· Identify all of your business risks.
· Quantify how each risk factor impacts your value.
· Prioritize which risk factor you want to focus on.
· Develop strategies and action plans to reduce the risk associated with each risk factor.
Some risk areas will take years to address while others can be minimized by simply purchasing insurance or making the right hire. Based on my experience, the following six areas are the most prevalent risk factors that impact business value:
· Employee issues: This is the most common issue that I add a risk premium for. Most privately held businesses have thin management teams and rely on a few employees to drive business performance. The loss of a key employee can significantly impact the company’s future cash flow. It is imperative that you build a strong management team and lessen the reliance on any one employee. In order to keep key employees, provide them with market compensation and a long-term incentive plan that rewards their performance. All key employees should have employment and noncompetition agreements. In addition, you may want to buy “key person” life insurance on certain employees. Your most important strategy in this area is to make yourself obsolete. This will significantly lower your risk and provide you with more freedom. If you don’t take this step, you will not be able to leave the business when you sell it. The buyer will have to retain you until you can be replaced. This not only reduces your value but will put you in the uncomfortable position of taking orders from someone else. It rarely works out for the seller.
· Customer concentration: In Chapter 2, I told the story about a company that had $90 million of its $100 million in revenues with one customer. The company’s value vanished when it lost this customer. Besides employee issues, customer concentration is the most common risk factor. The level of the risk premium associated with customer concentration issues depends on the following factors:
· Is there a long-term contract with the large customer? If so, the risk premium might be reduced.
· Why does the customer buy from your business? If it is simply based on price and the customer has many alternatives, then the risk premium is higher. If the customer buys because the product or service is unique and hard to duplicate, then the risk premium is lower.
· How healthy is this customer? Is the company near bankruptcy or financially sound?
· Does the customer buy based on a relationship with an employee at the business? If so, will the customer stay if that employee leaves the business?
The buyer or the valuator not only needs to understand the amount of revenues that come from the large customer but also quantify the true risk factor. At times, I have not placed a high risk premium for customer concentration issues. This happens when the risk level is mitigated by a long-term contract or by the fact that the client’s product is unique and needed by the customer.
· Low barriers to entry: Companies with low barriers to entry are more risky than those with a high barrier to entry. How easy is it for a competitor to enter your market? You may be making a ton of money, but if it is easy for a competitor to grab your market share, it is unlikely that the cash flow will be sustained. A good example of this is web page development companies. In the late 1990s and early 2000s, there were a few large companies that focused on developing web pages for businesses. They did quite well for a few years, but then most of the larger companies in this industry went bankrupt. Why? They created very large organizations with significant overhead, but the cash flow was not sustainable. The barriers to entry in the industry were very low. Soon, advertising companies and individuals were competing and the prices to develop web pages dropped significantly. I am not discounting the skill and importance of this service—I’m simply making a point. To get into this business, no license or college education is needed, and there is very little out-of-pocket costs. If you are skilled in this area, all you need to get into business is a computer, a business card, and the ability to market yourself. Compare this to a business that has a significant amount of intellectual property that is protected and requires millions of dollars of investment to get established. There are very few individuals or businesses that have the resources to compete with Apple or MGM casinos.
· Product sustainability: Today, products and services become obsolete much faster because of technology advances. If you don’t believe this, simply look at the current market value of Research in Motion (the manufacturer of the Blackberry). It is currently worth a fraction of its value five years ago. Why? The iPhone and Android phone technology has displaced the Blackberry. In order to determine the risk level for product sustainability, it is important to perform an analysis of where the company’s products are in the life cycle. Are they mature products in a highly competitive market, or is it new technology that is legally protected and will not face major competition in the coming years? To lessen your risk and make your business more valuable, make sure that you protect your products and processes and any other intellectual property legally.
· Inconsistent financial performance: Investors love cash flow that is repeatable when making an investment. If there are two companies that have averaged $500,000 a year for the past five years in earnings, which one of the following do you prefer? The one that has earned $500,000 each year for the past five years, or the one that had earned $2 million two of the past five years and lost $500,000 the other three years. Most investors would choose the former. The more volatility that you have in your historical earnings, the higher the risk premium.
· Litigation exposure: Litigation is a fact of life for business owners. This risk area, if managed properly, will not impact the value of a business. It is important that you have the right insurance coverage to protect you from product liability, malpractice, employee issues, and other business risks. A lawsuit against a business that does not have the proper coverage will impact value. The impact level depends on the size of the lawsuit and the probability of a judgment against the business. The same is true for violations against governmental agencies’ rules and regulations. A large EPA fine or assessment from the IRS will negatively impact your value. You can lower your risk by being diligent in complying with the governmental agencies that govern your business.
There are many other areas where a risk premium would need to be applied, including the following:
· Too much reliance on one supplier
· Labor availability and strife
· Government regulations that will impact future business
· Negative working capital and other balance weaknesses
· Aggressive actions of your competitors
We have seen Drew increase his value by increasing his gross margin percentage and lowering his operating expenses. Drew has decided to further increase his value by reducing the risk associated with his business. The first thing he does is to establish a plan to make himself obsolete in the business. He hires a corporate psychologist to assess the leadership abilities of his management team. It is determined that his daughter has the ability and desire to take over Drew’s CEO role. She enrolls in an executive MBA program and hires a works with the psychologist to expedite her progress. In addition, the sales manager and the plant manager sign employment and noncompetition agreements. With these changes, buyers will feel more comfortable that the business could survive without Drew. In addition, they will not worry about his key employees leaving and competing. With these changes, the required rate of return needed to entice a buyer is reduced from 25% to 20%. The following shows the impact on value with this risk reduction:
A change from a 25% required rate of return to 20% has made a big impact on value. The value has increased by $487,000! Drew is motivated to reduce his other major risk. He decides to no longer be so dependent on one customer. He hires an aggressive sales person who develops new markets and customers for his products. In addition, he stops selling his low margin products to his 30% customer. This combination reduces the largest customer’s sales to 15% of total revenues, and the top three customers now comprise only 30% of the revenues. By doing this, Sensational Snacks’ profits are no longer at the mercy of the three largest customers’ whims and demands and Drew’s earnings are more repeatable. By lowering his customer concentration and making his earnings more repeatable, Drew has reduced the required rate of return to 15%.
What is the value of Sensational Snacks assuming a 15% required rate of return?
Drew’s hard work to reduce his business risks has really paid off. The value of Sensational Snacks has increased from $1.95 million to $3.25, million with the reduction of the required rate of return from 25% to 15%. The required rate of return reduction is due to Drew proactively reducing the company’s reliance on himself and the one large customer.
Important Business owners should identify the risk factors associated with their business and have specific strategies and action plans in their strategic plan to reduce these business risks.
Developing a Growth Plan
The buyer’s perception of your future growth rate will impact the value of your business. The higher the expected growth rate, the higher the value of your business. You can increase the value of your business by developing a strategy to have sustainable profitable growth.
The compound annual growth rate (CAGR) measures the annual growth of a business over a certain period of time. What is most important is the buyer’s perception of future growth. The best way to improve that perception is to have a few years of CAGR higher than others in your industry. There is no better combination than a high historical growth CAGR and the expectation of continued growth. In a hot industry, growth is easier than a mature market. Most industries are mature, and growth has to come from taking business away from competitors or developing new products.
Of course, growth can come from buying another company. If you have a strong desire to grow quickly, this may be a good strategy for you. Is it better to buy growth or to have organic growth? Growth through acquisition can be an effective strategy if you don’t overpay and have a well thought-out implementation strategy. In most surveys about business transactions, less than 50% of acquirers are happy with the results of an acquisition. Why is that? They either overpaid or did not properly integrate the acquired business into their existing business.
When clients engage me to assist them in buying a business, I tell them to spend as much time in developing integration plans as they do in the pursuit of the deal. It is sort of like getting married. Many spend more time planning their wedding than figuring out how to live together in harmony for the rest of their lives.
Which should you pursue: organic growth or an acquisition? With some analysis, you will be able to answer this question. If your business has an opportunity to buy a company for $1 million, would you be better off buying it or spending $1 million trying to duplicate what you are buying? Prepare an analysis to determine the answer. Many are surprised by the end result and forgo their acquisitions plans, putting all their efforts into organic growth.
With the recent worldwide economic downturn, there is a hunt for growth for most companies. Growth is hard to find. What can you do to increase your chances of obtaining sustainable growth? There are three basic growth strategies to consider:
· Market penetration: This involves selling more of your products and services into your existing market. You develop a plan to obtain more customers through advertising, efforts of your sales force and channel partners, or price reductions. This is the easiest strategy to develop but usually does not create sustainable profitable growth. You are essentially just stealing customers from your competitors. The other problem with this strategy is that sales growth may come at the expense of your gross margin. You create value by increasing your gross margin percentage. Getting into price wars to gain market share lowers your gross margin percentage.
· Product development: For many, the best way to increase revenues is to develop new products or services that you can sell to your existing customers. Apple is the master at this strategy. Many of my friends have four or five Apple products and will buy the next thing that the company sells whether they need it or not. This can be much more profitable than stealing customers from your competitors. However, it comes with more risk and will cost you time and money to develop new products and services that may not be accepted in the marketplace. It is imperative that you spend a significant amount of time and analysis in determining if the marketplace really wants your new product or service before using this strategy.
· Market development: This strategy entails expanding your geographic reach, including international sales. With the advent of the Internet, this strategy is now available to many more businesses. You need to perform a good cost-benefit analysis before committing to this strategy. If it will cost you $300,000 to open up a new office in a different location, how much product do you have to sell in order to break even? Will you become distracted by the new location and lose focus? Can you maintain the same quality control in a different location? These questions need to be answered before proceeding with this strategy.
Buyers are attracted to you when you have a growth strategy you can articulate and there is traction in moving that strategy forward. They also are impressed when you are able to show them that you have a firm grasp about your marketplace. You should know what your market share is and, more importantly, your potential market share.
The final piece of increasing Sensational Snacks’ value is to implement a growth strategy. Drew develops a strategy to add a gourmet potato chip line and sells it to existing customers. It has been accepted by some of his customers and will increase his revenues by $300,000. The following is the new income statement after all of the changes discussed have been implemented. His net income has increased from $325,000 to $551,000.
The long-term expected growth rate has increased by 1%, which lowers the rate of return required by an investor to 14%. The value of Sensational Snacks with these changes is as follows:
Drew’s Newfound Freedom
The combination of increasing cash flows, lowering business risk, and increasing sustainable growth is very powerful. Sensational Snacks is now worth $3.94 million which is over three times the original value.
Can Drew retire? Assuming a tax and transaction cost of 30% of the enterprise value, Drew’s net proceeds from the sale of his business would be $2.76 million. His liquid assets have increased from $700,000 to $3.46 million. This along with his $500,000 of real estate brings his net worth close to $4 million. Now he is able to retire at the lifestyle that he wants, but he is unsure if he wants to retire. He enjoys going to work more than ever and may put off retirement for a couple of years. Instead, he will fund his retirement with the additional profits, making it possible to gift or sell the business to his kids at a bargain price. By treating his business “like an investment” and increasing its value, he no longer feels stuck and has many different options to choose from.
Before concluding this chapter, I would like to make one last point in making your business more attractive to potential suitors. If you are thinking about selling your business in the next five years, it is important to make your business look as professional as possible.
Professionalizing Your Business
What does it mean to professionalize your business? It is simply giving the impression to a buyer that your business has the look and feel of a well-oiled machine. It provides buyers with additional confidence that they are making the right decision to buy your business. It also protects the value that you worked so hard to create. It is tragic when a business owner has developed a great business model but then sees value destroyed by not paying attention to certain areas of the business There are six main areas that will make your business more professional and more attractive to a buyer:
· Upgrade your accounting and legal service: Which provides a suitor more comfort—financial records in a shoebox or an audit from a large reputable CPA firm? Business owners thinking about selling their business should have an outside accounting firm provide them with either reviewed or audited financial statements. An audit provides the highest level of assurance and a review is the next step down. It is also important to engage a seasoned business lawyer to review and update your buy-sell, employment agreements, customer contracts, and other important agreements. Many business owners have the same CPA and lawyer whom they started with. Make sure that the professionals on your team are the best ones to get you through the selling process. It may not be your golfing buddy or your spouse’s cousin who will be effective at making this happen.
· Employee manuals and job descriptions: A buyer wants to be confident that the business will continue to be profitable after a transaction. It is not unusual for there to be some turnover of employees once a transaction occurs. What creates the future cash flow? Employees! Buyers feel better about buying a business that has employee roles and responsibilities well documented. This makes it easier to replace someone and keep the cash machine moving forward. The more roles and procedures that are documented, the more assurance buyers will have when they buy your business.
· Compliance with government regulators: This includes complying with the IRS, EPA, and Equal Opportunity Employment practices and meeting governmental worker safety standards. A serious violation with any of these could cost your business hundreds of thousandsof dollars and perhaps your entire business.
· Proper internal controls to prevent theft: Each year, I hear about a trusted employee who stole hundreds of thousands of dollars. Recently, a client shared with me how a major theft had been discovered by accident. His payroll clerk got into a serious auto accident on payday. She tried to escape from the ambulance because she had placed a friend who did not work for the business on the payroll (a ghost employee). The owner figured it out when he had to hand out the paychecks due to her accident. It is important that you have the proper internal controls in place and be insured against theft.
· Effective corporate governance: Having an outside board of directors and/or an advisory board will provide you with an important sounding board. When the right people are chosen, they can provide you with solid business advice and help you avoid a major loss in value. Many business owners regret making major decisions without some additional advice and oversight.
· Identify and document your intangible assets: Intangible assets are critical to the success of all businesses. You want to make sure that buyers understand what they are buying when they purchase your business. They will know that they are buying inventory, fixed assets, receivables, and some intangibles (e.g., customers and patents). However, many intangible assets are much harder to identify. You need to communicate to a buyer all of your intangible assets that your business owns, such as the following:
· Market research you’ve conducted
· Processes and formulas for making products
· Your approach to customer service
· The relationships you have in the community and industry
· Experienced employees
· Proprietary products and processes
· Proprietary software that you have developed
It is worth your effort to document your intangible assets and legally protect the ones that you can (patents, trademarks, and copyrights). Products and ideas that are unique and provide you with a competitive advantage should be protected from outsiders through patents, trademarks, and other means. An idea stolen that is not protected can cause serious damage to your business.
There are ways you can make your business more valuable and attractive to potential suitors. Hopefully, the end result of what happened to Sensational Snacks has provided you with some motivation to develop plans to increase your business value. There are three key areas that you can focus on to increase your business value:
· Increase your sustainable cash flow.
· Reduce your business risks.
· Develop a growth plan.
As part of your strategic plan, develop strategies and action plans in each of these three key areas. Small changes can make a big difference in your business value. Also, improve your business hygiene and make your company look more professional and protect your value. You will attract more potential buyers, which will drive up the price of your business.
In the next chapter, I will walk you through the process of selling of your business from the time you decide to place your business on the market to the closing of the deal.