October 10, 2001
(Written by: Dr. Bruce M. Firestone, PhD., M.Eng.-Sci., B.Eng.(Civil), Chair of Hickling Capital Corporation, Adjunct Research Professor, Carleton University and Founder, Ottawa Senators Hockey Club.)
Many entrepreneurs are very good at building their businesses. They know how to grow a business often with limited access to financing. They know how to persevere in difficult circumstances and how to push the right buttons in their industry to make their business profitable. However, many business owners fail to optimize the value of their businesses when it comes time to sell it.
One local Ottawa based company experienced 15 consecutive years of growth and profitability before running into heavy weather in a recessionary period. The ownership group looked at selling a minority interest in their company to a major competitor for $500,000. At the rate that the company was then losing money, this would have forestalled the inevitable for about three months. Nothing would have been resolved on an operational basis and none of the money injected into the company would have gone to the founders and shareholders.
Their advisors suggested instead that they re-analyze the business with a view to: a) identifying and selling unprofitable operations, b) downsizing their head office staff and overheads, c) other operational efficiencies. The result of this work was that the company identified a number of locations that were unprofitable. These outlets were closed and the inventory and leases were sold. Indeed, market conditions were so receptive that the company recaptured a huge proportion of its investment in these losing operations. Head office costs were also dramatically cut. The slimmed down, more focused operation went from seven figure cash losses to seven figure earnings (true cash earnings) within two years. Several years later, the business was successfully sold at a handsome price in an all cash deal. These monies went to the founding shareholders of the company.
This paper is about the steps that need to be taken by business owners when they are in the process of selling their business. It is about the Do’s and Don’ts of the process.
The first step in the process is deciding whether to sell or not. Business owners, like many homeowners, sometimes conclude that they ‘will just test the waters’. This can lead to trouble, not a sale.
Selling your business is a serious step requiring a significant commitment of the owner’s time and resources. It is a step that can lead to a crisis in confidence on the part of employees, suppliers, banks, clients and customers if it is not handled in an appropriate manner. The decision to sell and the selling process needs to move forward in a timely manner to obtain the desired result.
Don’t make the same mistake that a friend of mine made. He had a dandy small business that employed himself, his wife and his uncle. He had an offer to buy his sign company for “a million dollars”. He was in his early 40s and had started with nothing so this sounded great. I asked him what he would do if he sold the company. “I dunno,” he replied.
“Well,” I said “if you take that whole million and invest it securely in say T-bills, you’ll get 4.5% today. That’s $45k per year. What are you and your family currently taking out of the business?”
“I get $80k and my wife takes home $60k for doing the books. Then we have a couple of cars paid for by the business and the firm still makes another $200k in cash earnings every year which we re-invest in the business.”
So he was exchanging a family income stream of around $140k per year plus giving up a business that still made north of $200k per year for $45,000 before tax! Not a very good deal.
What was his business really worth. Well, to have the same living standard afterward as before, he probably needed to sell the business for closer to $3m. Was it worth $3m? Well, only the market can determine this—a price is what a willing buyer and willing seller agreeto.
Once the decision to sell is made, the owner will want to have a notion of the value of the business. The true measure of the value of a business or, indeed, any product or service, is the price that a buyer and seller agree to. If we look at internet IPOs in the late 90s, we can find evidence that share prices are sometimes not related to past results, book value, earnings, cashflow, inventory or any other variable that can be measured. Prices may be based on expectations. Outrageous prices may be related to outrageous expectations. Businesses with a negative equity position and negative cashflow can sell for hard dollar amounts because the purchaser’s perception of value was based on what they could do with the business not what the previous owners had done to that point.
Valuing a business, then, requires
both a careful, fact based analysis and an application of knowledge and feel
for what the markets may accept. Business valuation is both an art and a
science.
Valuations may be based on multiples of cashflow, earnings before interest, taxes, depreciation and amortization (EBITDA), net income, profit, book value, sales, revenues, sunk costs, total investment, replacement cost, number of clients, customers and subscribers, expectations about the future and so on. Each industry will have different conventions to measure value.
The third step is to market the business and conclude an agreement of purchase and sale. The structuring of the deal involves issues including price, terms, security and timing; it also involves efficient structuring for tax purposes.
The fourth and last step in the process is investing and protecting the proceeds of the sale to meet the owner’s future goals and requirements. Business owners are known for taking good care of their businesses but paying inadequate attention to their personal affairs—it is an example of the shoeless shoemaker’s son or medical doctors who treat themselves or attorneys who represent themselves. A significant amount of effort and focus on personal investing is needed.
Simple but clever strategies for investing can make all the difference to present and future lifestyle. As smart as most business owners are, they are, for the most part, much like the rest of humanity—they behave like the grasshopper in the fable, fiddling the summer away while the ant is preparing for winter. Some care and attention will prevent the proceeds of the sale going the way of monies won by $5 million+ lottery winners in the USA- within five years, a surprisingly high percentage of the winners are worse off than before they won the prize.
1.
Valuing Your
Business
This is an absolute must before you sell your business. You need a professionally done, thorough going analysis that can stand the test of prospective purchasers’ advisors review. You will set up a ‘data room’ where pre-qualified leads can view confidential company data. Person who are allowed to examine the data are required to sign a NDA (non disclosure agreement) and they are pre-qualified. You don’t want your competitors to view your information unless they have been pre-qualified and they have agreed to treat the material as confidential and proprietary.
The penalties for not doing so (see the famous lawsuit of Volkswagen by GM for IP theft) are so stupendous that most persons who sign NDAs, take that very seriously.
Having said this, remember that once you have decided to sell, it won’t be long before pretty much everyone in your industry, your employees, your bank, your suppliers and your customers will know. The media will know too so you need a pro-active PR stance here. “No comment” is not an acceptable media strategy. You need to disclose but you need to be smart in how you do it.
Companies that are publicly traded have their share price set every day. The liquidity they provide their shareholders is one of the major reasons why public companies generally have higher multiples than private ones.
Exceptions do occur. Privately held companies with exceptional franchises can have significantly higher multiples. Government awarded franchises or licenses such as cable company monopolies or spectrum leases (like, say, television stations) or the fur trade monopoly granted by the Crown to the Hudsons Bay Company circa 350+ years ago can attract huge bids. Companies with specialized proprietary (patent protected or trade secret) technical expertise or technology may also qualify for exceptionally high multiples.
Most privately held firms are family owned, operated by entrepreneurs. Valuing these firms is done using a variety of approaches: a) replacement value, b) breakup value, c) earnings multiple, d) comparables.
Replacement value simply asks, “If a competitor came into the business, what would it cost them to establish this business from the ground up?”
Breakup value looks at the market value of individual assets—essentially, the value of the components on a stand-alone basis. For example, what is the stand-alone value of the underlying real estate? Is it more valuable separately in a sale or combined with the operating business? What is the value of the operating business? What is the value of individual lines of business? What is the value of the machinery and equipment in, say, another use? What is the value of the inventory if sold off?
Sometimes, the breakup value is the highest value for a business.
Earnings are very important in every business. Profitability is necessary not just to ensure that the business survives or that ownership has a nice lifestyle, but also because profits can be reinvested in the business so that it can employ the latest in technique and technology, so that it will grow and so that employees and suppliers, all stakeholders in fact, are more secure.
So, generally, when selling your business, you add back into earnings all the benefits derived by ownership together with cash items such as interest, amortization and taxes as well as non-cash items such as depreciation and, presto, you have a ‘true’ measure of cashflow—EBITDA (earnings before interest, taxes, depreciation and amortization). This is, perhaps, the most important measure of the underlying earnings potential of a business. To a prospective purchaser, it allows them to put in place their own capital structure and measure its efficacy against the EBITDA numbers of the acquisition.
Multiples vary from industry to industry and even within industry.
Lastly, you want to compare what other people in your industry have sold similar businesses for. Afterall, ultimately the value you obtain depends to a large degree on intangibles like the perception of your business in the marketplace. You will need to employ a third party who can provide an arms length analysis as to value and can give prospective purchasers a level of comfort with the overall arrangement—they provide third party testimony as to value. They will also have to ensure that they make the market aware of the opportunity and that the information about your business is disseminated in an appropriate way to the right audience, some of whom will be your competitors.
2.
Marketing Your
Business
Business owners and management usually need outside assistance when they are planning a significant change in direction. This may involve selling a division, some assets, subsidiaries or the whole company. Mergers and Acquisitions firms, consulting businesses, real estate agents and Merchant Banks provide strategic and independent advice. Large firms regularly avail themselves of these type of experts. Medium size and smaller firms rarely do, which can result in much lower values being realized in the process.
For on-going operations, one of the keys to profitability is the ability to identify what is and is not a core operation. Then the challenge is to realize the optimal value for the discontinuing or contracted out operations. Some professional sports teams are very good at this. They realize that the core competency of their franchise is putting a good product on the field, ice, court. They manage internally their most valuable assets—their season ticket base and key relationships with the corporate community and sponsors. Beyond that, they do a lot of contracting out—for parking services, cleaning services, food and beverage, catering, security, arena management, merchandise, television rights and other media properties. Many technology companies do the same type of thing.
By drawing ‘lines’ and ‘circles’ within a business, value is optimized.
An insurance company realized that they had a very valuable real estate asset on their books at its depreciated value. Ownership and management came to the conclusion that they should sell the real estate and focus on their core business—selling insurance and servicing their clients. The substantial proceeds of the sale went to strengthen the company’s technology and the balance was taken out by the owners for retirement planning purposes.
Business owners who are preparing to sell their businesses will want to improve the bottom line performance to enhance sale value. Timing is critical.
Owners can fall in love with their business when times are good. When the business is not performing as well, owners may want to sell. They may lose interest. They may lack the energy and enthusiasm to implement needed changes including downsizing and other tough options. This is the worst time to sell.
One private radio station climbed to the top of its market in terms of ratings and profitability after 15 years of arduous effort. The owner, near retirement, was advised to sell at that point. The owner declined. Within two years, competition in that marketplace intensified with better capitalized, national firms moving in. The result was a tumble in ratings and profitability and a ten year wait before another opportunity arose to sell the station.
How long does it take to sell a business? Longer than most people would like. Yet it is imprudent to expect to sell a business in a hurry with a quick closing. This is not realistic and results in most if not all of the value of the business being given away.
Allow sufficient time for the process to work its way through- a) six weeks to three months to put together a due diligence package, a data ‘room’ and a marketing package together with time spent on strategic issues and valuation, b) two to nine months actively marketing the business, c) due diligence period of two weeks to one month, d) closing within 30 to 60 days. This process assures that the widest possible net is cast to bring competitive bids or offers to the table and optimize the value received.
Care must be taken in deciding to whom the business is sold. No matter how well drafted the closing documents are, disputes can arise. A purchaser who is reputable greatly decreases the likelihood of litigation and increases the probability that all the terms and conditions of the agreement of purchase and sale are lived up to.
Earnouts and consulting contracts for previous ownership and management require careful drafting and good security.
Bringing in a minority partner or 50/50 partner or new majority partner are options that can be troublesome. There are, after all, still two vacant chairs in heaven waiting for the first partners to get there and still like each other. One industrial real estate company that brought in a 50/50 managing partner experienced a jump in vacancy rates over the following two years. The new operating partner was, as it turns out, enticing existing tenants to move into buildings that were 100% owned by them. The result for the original owner was near vacant structures and a subsequent distress sale of his part interest.
Where does one find a buyer? Some likely places to look include: a) existing partners, employees or shareholders, b) management, c) competitors, d) narrowcasting advertising, e) data bases, direct mail and contact, f) personal contacts, g) recent graduates, h) golden parachutes or persons affected by downsizing with severance packages, i) outplacement agencies, j) real estate agents, business brokers, accounting firms, legal firms, merchant banks, banks, k) word of mouth, l) serendipity, m) customers, n) suppliers, o) strategic partners (others in a closely related, but not the same, business).
Hiring a consultant will allow the business owner to probe some of these areas (such as competitors) with some degree of anonymity; a description of the business on a generic basis and a third party to handle responses and pre-qualify them, can be helpful in this regard.
However, it is unrealistic to expect that a business or any part of it can be sold without employees, customers, suppliers, banks and the media coming to a realization that this is occurring. Therefore, the company and its advisors need to have a media strategy and a strategy for handling the concerns of other stakeholders beforehand.
The company also needs to be comfortable with full disclosure of all opportunities and problems that it is experiencing. Lack of disclosure leads to failure either during the due diligence period or after closing. That does not prevent the company and its advisors from casting problems in the form of opportunities; what is a problem for existing ownership (eg., a failure to penetrate a certain market) is an opportunity to the purchaser.
Business owners often are too close to a business to see its upside potential. They know all the problems and they are immersed in fixing them day to day. What the buyer needs to see is the opportunities. A third party consultant has the advantage of perspective and impartiality. A third party who can play the role of conciliator bringing two or more parties together to complete a transaction is key.
The company should take pains not to bid against itself. It is not necessarily bad strategy for the company to take the initiative and set a price; it is bad strategy to take the initiative and then revise the price without feedback from prospective purchasers. This is known as negotiating against yourself.
3.
Investing and
Protecting the Proceeds
Get a professional advisor and put at least half of the proceeds in very
tame and safe investments.
4.
Get a (New) Life
Nothing is worse for the entrepreneur that inaction. My father told me:
“Never retire.” What he meant was plan ahead and do something, different
perhaps, but do something.
People aren’t meant to be idle and it damages your mental and physical
health. Often, entrepreneurs will return to their original businesses because
they are comfortable with it. So don’t sign non-compete agreements longer than
one or, at most, two years.
I asked an acquaintance of mine: “Why is the ______________ Teachers Fund
so wealthy? They seem to buying up the whole country.” He replied: “Heck, the
average teacher only collects for about 18 months.” “How come?” “Because they
die that soon.”
This should reinforce for you how important it is to keep active, stay
plugged in and engaged.
One of my early mentors took early retirement at 55 and moved to FLA. He
was cut off from his lifelong friends, much of his family, his place in his
community—his roots, if you will. His Florida day consisted of a walk in the
am., lunch, nap, second walk on the beach, cocktails, an evening of television
and bedtime. Within six months, he was dead of a massive heart attack—he was
dead before he hit the floor with his oldest son sitting six feet away. You get
the message. Find a new mission in your life.
Copyright. Hickling Capital Corporation, Ottawa, Canada, October 2001.
Twenty Five Steps