When a business is launched the hope is that the chosen market segment is a blue ocean and the opportunities vast. In the beginning, the choices as to how a business will grow are wide open and the decisions made today will influence tomorrow’s final stage in the life cycle of a business—the exit.
The exit goal for the vast majority of privately held business owners is to sell the business to a third party in an effort to receive the highest return on investment for all of the capital, expertise, and time invested in building the business. As a business owner heads towards the final phase in the life cycle of a business the big question is:
- Has the owner created a business with transferable value that a buyer can capitalize upon, meet their ROI expectations, and therefore is willing to pay a lofty price?
Simply put, transferable value is the worth of your business to a buyer without you in it and it is the cornerstone of an exit plan. For a business owner who intends to exit via a third-party sale, how high a price an owner receives is dependent on all of the decisions made as they built transferable value.
Most privately held business owners tend to believe that value is solely about profit. They focus upon increasing sales, margin growth, and cutting expenses. I often hear the 5x5x5 rule from owners. They believe that if they increase sales 5X, increase margins 5X and lower sales, general, and administrative (SGA) expenses 5x they have increased value. It’s not that easy.
Simply growing sales is not the solution. I worked with a client who had a great business with 63 MM in revenue, 14 MM in EBITDA, no debt on the books and they were analyzing the impact to take on a new customer that would add 10 MM in sales. Will that additional sales volume increase the business marketability in the eyes of the buyer? As it turned out no. The additional sales would stress the operational capacity requiring a capital infusion to expand operations and this would result in adding debt onto the balance sheet. In addition, there was no evidence of economies of scale — costs were not going to decrease with more units sold so margins were not going to increase.
I have spoken with many a business owner who believed that if they grew their sales they would be in a better position when it came time to sell, only to find out that they ended up needing to expand their operation and add more employees. Ultimately the demands placed upon them went through the roof with no increase to the bottom line. Just more headaches.
Increasing sales alone will not build transferable value. It is critical to also focus on qualitative factors that drive profitability, growth, and the strength of an organization.
Here are six steps that will increase transferable value and make the characteristics of your business more attractive to buyers:
Business architect: When a buyer is considering buying a business, scalability (the business can be expanded easily without a major capital outlay) is vital. A buyer wants assurance that an increase in revenue will result in a corresponding increase in profit margin. It’s not always possible; for example, when I worked as a CPA for PricewaterhouseCoopers an increase in revenue did not result in an increase in profit margin as the cost (time) increases equally. A product-based business can be easier to scale. I’m working with a software company right now and that business is easily replicable—the software is developed so as the revenue grows from additional sales there will be incremental expenses, but no more development expenses and the profit margin soars.
A buyer will also be evaluating the market share potential for future growth and whether your business can easily accommodate the growth. Years ago, when Oprah featured products on her show, the failure rate of the highlighted businesses was enormous because the operation was not ready to accommodate the growth. The good fortune of being on Oprah was negatively dubbed the “Oprah effect.”
Step 1: Evaluate your business and the potential to scale. Be mindful of market demand. Note that you may not have replicated your business because of lack of capital or knowledge, but if you can prove it is possible to scale your business and that there is market demand your business will be much more attractive in a buyer’s eyes. And don’t make the mistake of holding onto a business too long. The ideal time to sell is way before the business peaks. Remember a buyer is investing in future growth potential.
Management Team: Having a well-developed management team assures an investor that that the business is not owner dependent and that if you are no longer part of the equation the business will continue to expand. Human capital is one of the greatest intangible assets a business develops and if your exit strategy is to transfer ownership to a third party via a sale the quality and depth of your management team will impact your success in meeting that goal.
It seems, however, that attracting, developing and retaining talent is the bane of every entrepreneur’s existence. I hear the struggles of building out a solid management team: “the unemployment rate is at an all-time low and I can’t find anyone who can do the job.” Or one of my favorites: “Nobody wants to work hard anymore.”
I understand, but without a solid management team in place your business will be considered a high-risk investment. The higher the perceived risk in the eyes of a buyer the lower the price paid. The inverse is true too. Greater quality of management means less risk and a higher price paid.
Step 2: Evaluate the quality of your management team and identify any gaps in talent. Begin with your organization chart. I had a client once who had no marketing director and wondered why sales were so inconsistent. Once you have identified your voids prepare a plan to attract, develop, and retain talent. Strive to make yourself obsolete in your organization. In addition, be sure to have succession plans for key employees in place. This is vital considering how many baby boomers are entering retirement age.
Documented Systems and Procedures: A well-documented business lowers the perceived risk and transferable value is increased. An Ocean Tomo study analyzed buyers’ purchase price motivation and found a whopping 84% of an investor’s purchase price was attributed to a buyer buying well-documented intangible assets. It is also important to ensure your accounting is clean and all financial controls in place.
Step 3: Assess how well your business is documented. Have you clearly documented the operations, how technology is utilized within your business, the approach to identify, attract, train and retain new talent, the marketing program that drives sales, customer service protocol, financial controls and procedures? How well should your systems and procedures be documented? Clear enough that my grandmother could come in and run your business. Identifying and documenting the intangibles will drive your selling price.
Revenue Character: Not all revenue is weighted equally through the eyes of a buyer. For example, being paid post project is not as attractive as a model in which the customer pays upfront or incrementally for your service or product.
The real gold standard for an investor is recurring revenue. A buyer is ultimately buying a business for a future predictable revenue stream. A buyer will pay more if a business demonstrates recurring revenue. For example:
- Service Contracts
- Automatic renewal product, service, or content subscriptions
- Strong customer retention rate
Step 4: Analyze your revenue and strengthen any recurring revenue opportunities. When renewing contracts try to extend the contract for as long as possible and create a sticky revenue stream in which a customer needs to come back to repeatedly.
Customer Diversification: Most investors don’t like to see more than 15% of revenue coming from a single customer. This often can be tough for an entrepreneur who nabs the big whale of a client who absorbs all their time, however, a well-diversified customer base removes risk for an investor so it is critical to be mindful of the spread of revenue. This being said I spoke with a colleague recently who said they sold a company with just six customers, “6 really good blue chip” customers!
Step 5: Calculate revenue by customer and industry noting profitability. Strive to diversify your base as much as possible with high margin customers. If you find a dominant industry ask for referrals from existing customers to add depth to your customer list. You don’t have to get rid of the big whale – just get more of them!
Positive Cash Flow: Showing an investor that the business is able to fund future growth through cash flow will go a long way in proving value to a buyer. Be mindful of your growth rate and utilizing your working capital efficiently. Working capital measures the company’s operational efficiency and short-term health. It is important to strike a balance. A buyer does not want to see liquidity issues in which they will feel they will need to invest heavily in order to realize the growth potential. Conversely, an investor will be mindful of excess reserves in which the business is under utilizing capital in order to drive revenue.
Step 6: Understand the liquidity of your business by calculating working capital or the current ratio of current assets divided by current liabilities. A rule of thumb is a ratio between 1.2-2.0 is considered good, meaning there are enough liquid assets to cover short-term obligations. If the computed current ratio is less than 1.0, liquidity is potentially an issue and a buyer will be concerned about future requirements to infuse the business with capital in order to meet their return on investment expectations. On the contrary if your ratio is greater than 2.0 that may be a red flag that excess assets are not being effectively utilized to maximize revenue. This is a general rule so I recommend researching your industry to understand working capital specific to your business. Once you understand your current working capital position you can then create and execute strategies to improve your cash flow. Positive cash flow = higher price.
All of the decisions made along the way as a business owner builds a business, whether big or small, impact the success of the exit strategy. Focusing on continually increasing transferable value will increase the attractiveness of the business in the eyes of the buyer and ultimately drives the business owners return on investment in building that business over years or perhaps decades.