As a business owner, the time will come to part ways with your company. While you might do this by passing the business on to one or more of your children, it is more likely that you will sell to an outside buyer. it is important to deal with the sellability of your business early on, for two reasons:
- Part of your life’s compensation is tied up in the potential capital gains from your business. About 75 percent of businesses that go on the market don’t sell. This means that owners really have little or nothing to show for years of hard work, often with little compensation in those years.
- Ending your involvement with your business is bound to be an emotional undertaking, especially if your life’s work is tied up in it. Most business owners are immensely proud of their enterprise and have a lot of their own sense of self-worth connected to it. Selling will be difficult.
FACTORS THAT AFFECT SELLABILITY
If we look at the reasons for a company not selling, we can identify the factors that need to be addressed to make your business attractive to potential buyers.
- It is not the optimal time to sell.
- It may be too early. The company is still too small or has not had time to hit its stride. It is still lacking in financial information or organizational structure. To be sellable a company must be bringing in enough EBITDAto finance the owner’s salary and the acquisition of the company; for example, $250K, $120K for the owner’s salary and the rest to pay for the acquisition.
- It may be too late.There are three scenarios here: (1) You the owner have become tired; sales have flagged; the company has lost its purpose; or the company has lost rather than added value. (2) You turned down a once-in-a-lifetime opportunity from someone who wanted to gain a foothold in the Canadian market by buying your company or your competitor. There will not be another opportunity like this, and you will have to settle for a significantly lower price when you do decide to sell. (3) Your risk aversion has caused the company to slow down and miss opportunities. If your company represents so much of your total assets that you are afraid of making business decisions because of their potential negative impact, then it is time to sell to a bigger company whose owners can better afford these decisions.
- Too early or too late. In some cases the owner knows it is the right time to sell, and it has been for a while, but does not know what to do next. The owner may not be psychologically prepared for the event, or does not know what to do next, and makes rationalizations — the price is not right, the selling process is too long and strenuous, etc.
|An Example of Selling at the Right Time
A property services company had grown to the point where it represented 2/3 of the owner’s net worth. The company had a good business model and was profitable, but it needed to grow, because it had no brand recognition, even within this fairly specific industry, and was susceptible to competition. In order to grow it needed investment in technology, marketing and product development to address rising regulatory requirements. This needed capital, but the owner was not keen to take the investment risk. A potential buyer who had the resources was available at the same time, and the company sold for well over $10M.
- Financial information is lacking.
When someone buys a company (and not just assets such as trucks and machinery), they are buying a cash-flow stream. The company’s financial information must reliably indicate what the cash flow has been and what it will be.
Potential buyers frequently ask:
- How reliable are the annual financial statements? Are they backed up by a review engagement report, or even better an audit report? These reports provide more assurance that the numbers are reliable and in accordance with GAAP.
- Does the company prepare budgets? Is there evidence that they are used to manage and improve financial performance and position? If financial information is rarely used, the probability for detection of errors decreases. The first suspicion of major fraud or error often occurs when finding that the variance between actual results and budgeted numbers is unreasonable and cannot be explained.
- Is the financial information current and relevant? Does it show that the business model is working or not working? For example, can an acquirer ascertain what your breakeven sales are, or what it would cost to increase output by 10 percent?
- Does the company prepare (and use) key performance indicators (KPIs)?
- Do the financial statements include personal expenses, so that an acquirer has to restate the financials? For example, if the owner’s salary is included, it must be related to a market rate; if the company owns a building, the rent must be at market rate.
- There are organization and contractual barriers to selling.
There are at least three organization and contractual barriers that need to be worked out before a company can be offered for sale:
- The company has several partners with different objectives for the sale. For example, one partner may be happy to have the proceeds of the disposition paid over time, whereas another partner may want to take cash immediately even if that means a lower price. To have an effective sale the vendors must speak with one voice.
- The company has an intricate ownership structure; for example, the company may be owned by several family members that span several generations.
- The company cannot assign vendors, leases or customers to the buyer. This is less common but still does occur.
- The company is too dependent on the owner.
If a company owner does everything or must make every decision, they are not selling a business, they are selling a job. Problems with staffing usually lead to this situation.
- Staff turnover is too high. As a result, vendors and customers always go to the owner because there is no-one else familiar with the business.
- Staff are inadequately trained and unproductive. The owner must do much of the work instead of having staff do it.
- There are no clear job descriptions or procedures. Staff must therefore come to the owner for all directions and decisions (which is why some of them leave). There is no real management team apart from the owner. The owner does not want, or does not know how, to delegate.
- Staff turnover is too low. Most staff have been there for decades. All the key knowledge of how to run the company resides with a few employees who would likely retire if the company is sold. Many staff members are there out of personal loyalty to the owner and of the owner’s personal loyalty to them. They have not received training in years, do most functions by rote, and are not particularly productive.
- The company has a very high customer concentration.
- The company has a few large customers. Perhaps their biggest customer represents 50 percent of their revenue and it is very profitable. This is especially prevalent in service industries. They often start with one big client and provide many services for that client. Then the sales representatives find themselves busy servicing existing, profitable clients, and do not prospect for new clients. Acquirers of companies typically do not want a single customer to represent more than 15 percent of the business.
- There is no recurring revenue.
- If an acquirer does not know whether or not revenue will cover next month’s operating costs, the risk is higher and the price will be lower. Therefore, a company needs to establish some type of recurring revenue. There are several types of revenue that will serve this purpose; some are more desirable than others (see table). Acquirers will pay more for companies the higher you go up this value chain. They will pay more for ‘sticky revenue’ such as subscriptions. On the other hand, with a revenue stream from a coffee shop chain there is more unpredictability; you may get 60 percent steady revenue for a few days of the week, but this can easily change.
Six Types of Recurring Revenue
From Least Desirable to Most Desirable
|Rank||Type of Recurring Revenue||Example of Company||Description|
|5||Sunk money||Nespresso (client has already purchased machine)||Habit with an investment|
|4||Subscription||Magazine publisher||The magazine can count on your money for a period of time|
|3||Sunk money subscription||Bloomberg (client must make an investment in a terminal in order to subscribe to data)||Subscription with a capital investment|
|2||Auto-renewal subscription||Internet security provider||No stop. Inertia can lead to long term revenue|
|1||Contract||Cell phone provider||Legal obligation to buy|
Source: John Warrillow, Founder of the Value Builder System.
- The business is not scalable.
Scalability, or the ability to grow, is connected with both the dependence of a company on its owner and on customer concentration.
- First, if the owner really oversees everything, no new locations can be opened. They cannot be two places at once. There must always be a manager of a store, a division, or a geographical area who has the authority to make certain operational decisions.
- Second, if a company performs many services to only one or a few companies, they generally have no point of differentiation.
For example, professional services firms that specialize in an industry grow 90 percent faster than those that do not specialize (Lee Frederiksen, “Secrets of High Growth Financial Services Firms,” NACVA Video Network). They know this industry intimately and can provide, and be seen to provide, expert advice.
HOW DIFFERENTIATION CAN HELP
As an owner, you might ask yourself whether to diversify your business or specialize. Diversification is not the answer to making your business more sellable. It is good for preserving wealth, not creating it. Bill Gates made his fortune from Microsoft and Microsoft only. Now he is diversifying to preserve his wealth.
On the other hand, when you create just one product, you can pour all your marketing dollars into that one product and make it distinctive. Take Apple for example. Apple has a quite limited product range. They also have recurring revenue through subscriptions, but more importantly, in total they have a billion customers and maybe a few dozen products. Other companies that are being sold to tech companies, such as LinkedIn, YouTube and WhatsApp, all have a very limited product range but sell to millions of customers.
An advertising agency has few customers and does everything: design, brand positioning, visual identity, website, digital marketing, trade show planning, advertising copy. All of it is good; none of it is excellent. Customers can always find someone who does one piece better.
· Do just one thing, e.g. visual identity, for a limited type of customer, but do it very, very well.
· Instead of doing ten things for one customer, do one thing for ten customers.
How differentiation improves sellability.
Differentiation deals with many of the factors that affect sellability.
- Dependence on the owner. By concentrating on one or a few things, you can more easily train employees and the company becomes less dependent on you. Take the example of a marketing firm. Its services could include branding, logo design, marketing strategy, marketing execution, web development, digital media and more. However, no one can be an expert in everything and, for a small firm, doing all of these things will lead to mediocrity. If you do one thing, you can hire someone with a basic knowledge of the field and train them.
- Customer concentration. With specialization, you can concentrate all your product development money on this product and you can focus your marketing to bring in more customers. Think of Apple again: one billion customers, a few dozen products. Or let us say that you specialize in doing digital marketing for dentists. That is very specialized, but every single dentist could be your customer, and because you are so specialized, many dentists will likely buy your services.
- Recurring revenue. It is much easier to implement a recurring revenue stream if the company does one thing or a few things. To take the marketing firm again, it would be easier, for example, to create a monthly subscription service or to create a fixed number of blog posts on social media, than to offer the entire marketing endeavour. With recurring revenue you do not have to start at zero every month. If you are selling project-based services, you have to constantly replenish the pipeline. If you have an accounting firm, for example, you have annual tax financial statements and tax returns. This provides a base on which you can grow consulting and specialized tax work. You can also grow through acquisition.
- Scalability. With less dependence on the owner, more customers, and recurring revenue, the growth of the company becomes more achievable.
What sort of differentiation?
It is best to offer something that is valuable, teachable, repeatable. Take a photography business as an example. There are different types of services possible –individual and group portraits, weddings, corporate events, school photographs. Portraits and weddings are not very repeatable. Corporate events can be a little bit better, but they are still not all that repeatable and may require more skills to do them well. School photographs are the best. They are done every year, parents are willing to pay well for them, and the skill level required to shoot them is not so high.
Attributes can be in conflict, however. What is valuable to a customer is not always very teachable to an employee. The solution is to start out small. A plumbing company, for example, has three alternatives – (1) new residential installations, (2) renovations and repairs, and (3) subscriptions to come and fix something when things break down. Number one is repeatable and teachable, but not valuable. Further, subcontractors on new installs are squeezed to the bone. Number two is more valuable, but less teachable and not repeatable. Number three can be valuable (depending on the pricing), but is the least teachable. The solution is to start out small. The plumbing company could carve out a small portion of its business (e.g. winterization of cottages or checking plumbing in restaurants) where it could achieve a steady stream of revenue through work that is teachable.
|Advantages of Differentiation|
This article has focused on what makes a business desirable to a potential buyer and what steps can be taken to improve sellability. Differentiation, or specializing in one or a few things, is the recommended solution. It will make your business less dependent on you, increase the number of customers, bring in recurring revenue and, most importantly, improve the ability of your business to grow. With financial statements in order and any organization or contractual barriers removed, your business will be sellable when the timing is right for you.