We often talk on this blog about ways to diversify wealth from the base of successful closely held and family businesses. Many of the methods we have discussed, like dividend policy, special dividends, leveraged dividends and leveraged share repurchases, specifically do not involve the sale of an entire business. I am not an advocate of anyone selling a business unless it is the right time and thing to do or, in some instances, the only thing to do. However, it is a good idea to be sure that your business is ready for sale at any time.
We just don’t know when the time will be right or that an irresistible offer will come along. If your business is not ready for sale when such opportunities arise, you will miss out on significant potential benefits in a lower than ideal purchase price.
In my experience, a business that is ready for sale is, first of all, lots more fun to work in than one that is not ready. And a business that is ready for sale is, well, ready for sale if an appropriate opportunity comes along or when it is appropriate to engage in a partial sale (or purchase) of a portion of the business through the judicious use of leverage.
Is Your Business READY?
Over the years, I developed a shorthand concept to address the question of whether or not a business is ready for sale. I use this shorthand concept when I value businesses and when I talk to business owners.
READY is a tool, or filter, through which to look at your business. So let’s ask the question: Is Your business READY for sale?
R stands for Risk
E stands for Earnings, or EBITDA
A stands for Attitudes, Aptitudes, and Activities and is all about the People of your business
D stands for Driving Growth (I know, I cheated a bit)
Y stands for Year-to-Year Comparisons
As we begin to talk about READY, recall that business value is all about expected cash flow, the expected growth of cash flow, and the risks associated with achieving the expected cash flows. This flows from the basic valuation formula:
Value = CF / (R – G)
We will relate the components of the valuation formula to illustrate how the concept of READY will help keep focus on building value.
The R in READY Stands for Risk
The algebra of risk is quite straightforward in the basic valuation formula above. R, the discount rate, is in the denominator of the basic valuation equation. Increasing risk therefore decreases value, other things being equal. However, the equation works both ways – decreasing risk, other things being equal, increases value.
At the outset, as we talk about risk in business, let’s agree that there are two kinds of risks – those we can do something about and those we can’t do anything about. I sometimes refer to these as “controllable” risks and “uncontrollable” risks.
It may seem obvious, but as business owners and managers, it is far more productive to work on controllable risks than to worry about uncontrollable risks.
Uncontrollable risks relate to the level and direction of the national, regional or local economies, the level and direction of movement of interest rates, industry conditions, and the general availability of financing, among other factors.
Controllable risks relate to everything else. But remember the famous quote from George Orwell’s Animal Farm: “All animals are equal, but some animals are more equal than others.” Well all “controllable risks” are controllable, but some are more controllable than others. It is therefore wise to focus on reducing risks where management can have the most direct impact in the short run, and addressing other risks over time.
Some of the most obvious risks in businesses relate to concentrations. Businesses can be “concentrated” in a variety of ways.
Customer concentration is one that obviously comes to mind. A customer concentration exists when one, or even a few, customers account for a significant portion of a company’s business. I’m going to tell the very short version of a very long and painful and true story.
For many years, we valued a company each year for purposes of its ESOP. The company was a paper distributor that supplied paper products in its region. About half of its business came from one fast food chain. Within a week of its main customer being sold to another, larger fast food chain, our client lost its largest account. The account was lost not due to bad service or poor quality, but because the larger chain had its own favorite supplier. Needless to say, the company’s earnings were devastated. It was only through Herculean efforts of management that the company was able to survive, and it took many years for it to regain its former sales or earnings levels. Needless to say, it was then a more valuable company, because it replaced the lost business with a diversified group of new customers.
So customer concentrations add risk to a company’s earnings and tend to dampen value. We had considered this risk in our appraisal, but if you think about it, there is no way to fully account for the risk when it is so binary in nature. One day the customer is there, and the next they are gone. And you don’t know what day it will be or why it might happen. So it is a good idea to focus on your concentrations to do what you can over time to minimize their impact on the future of your business.
Other concentrations can be in products, markets, suppliers, locations, sales persons, managers (key persons) and others.
Still other risks can impact value. For example, there is a correlation between market multiples and size. Larger companies are perceived to less risky than smaller ones. Leveraged companies tend to be more risky than are well-financed businesses (although some theorists will tell you that leverage won’t impact the value of a firm). Rising leverage tends to reduce options which increase risks.
Back to customers for a minute as we conclude this short discussion of risk. Years ago, I worked with a very successful stock broker by the name of Wally Lowenbaum. We were traveling visiting Wally’s institutional customers to talk about (sell) bank stocks in England and were having dinner one evening. I asked him: “Wally, what is the secret of your success?”
Wally responded, “Chris, I’d have to say that there are two things that I think about all the time. The first is momentum. If you don’t have momentum in your business, you have to do everything in your power to get it. And if you have it, you have to do everything in your power to maintain it. Momentum is a critical key to success!
The second key to success is customers. You can’t make money without customers, and too many brokers [substitute your industry] lose too many customers to really succeed.”
I asked Wally, “Well, how do you keep customers?”
Wally replied, “Chris, most brokers [substitute your industry] don’t lose customers because they lose money for their customers. If you’re in the brokerage business, that is going to happen. Most brokers lose customers because they ignore them while they lose money for them! Brokers who work with their clients in good times and bad will tend to keep them, and that is exactly what I try to do.”
Personally, I’ve never forgotten this advice, and I’ve tried to follow it ever since – and this dinner occurred in 1980. Wally was all about not being complacent in your business.
So remember that the R in READY stands for Risk. If you can reduce risk, all other things remaining the same, you can increase value, make your business more attractive to potential buyers, and continue the process of getting or maintaining your business in a ready for sale mode.
The E in READY Refers to EBITDA (Earnings)
Earnings are important to business valuation. Remember the CF, or Cash Flow, in the basic earnings equation. Cash flow is in the numerator, so an increase in expected cash flow, other things being equal, will increase the value of a business. As we talk about earnings, we will talk about EBITDA. EBITDA is the broadest measure of earnings to look at, and it is considered to be important by everyone who buys companies. What does EBITDA mean?
Earnings Before Interest, Taxes, Depreciation and Amortization
Think about EBITDA by beginning with pre-tax income, which is precisely Total Revenue minus Total Costs (except taxes). Now, add interest expense, the payments you make for borrowed funds, depreciation, which is a non-cash charge to replenish your investments in fixed assets, and amortization, which is a non-cash charge to amortize any depreciable intangible items on your balance sheet.
When buyers begin with EBITDA, they are thinking in terms of gross cash flow available from a business to meet all obligations and to provide a return on the capital invested in it. When I talk about buyers, I’m talking about the most likely buyers for businesses of any size, either private equity funds or other companies.
From the EBITDA base level of cash flows, buyers can begin to make decisions about how to utilize that cash flow in an acquisition. In other words, if they have a handle on the capacity of your business to generate EBITDA, they can assess:
- What their capital expenditure requirements will be
- How much debt they can safely carry in an acquisition. In other words, they can estimate, at prevailing interest rates and borrowing terms, the amount of debt-service they can handle (principal and interest)
- The interest and depreciation are tax-deductible, so they can then estimate their net income and capacity to pay down debt over time
- Then, given the amount of their equity contributions to the deal and the structure of their financing, they can calculate their expected return on investment, probably using some form of internal rate of return analysis
The forecasts of expected returns, in relationship to the expectations that various buyers have for future returns, i.e., their required returns or discount rates, establish the relevant range of pricing that rational, financial buyers are likely to pay.
This process I’ve just described is the manner in which the market determines whether your company will be worth, in terms of multiples of EBITDA, 4x, 5x, or 6x, or more, or less — or much more, or much less. I might add, that a little competition among buyers who find your company attractive will also help!
So, when I say to focus on Earnings, or EBITDA, there are very good reasons for you to do so.
The A in READY Stands for Attitudes, Aptitudes, and Activities
I’m cheating a bit because the A in READY is all about the people in your organization. We can ask a number of good questions for you to think about:
- Are the right people in place?
- Doing what they should be doing?
- When and where they should be doing it? And,
- With whom they should be doing it?
Other critical questions to ask and to work on over time include:
- What is the attitude and culture in your business regarding customer service?
- What is the attitude and culture in your business on product or service quality?
- What is the attitude and culture in your business regarding sales?
Years ago, I got out of the Army while still stationed in Europe and traveled for a while. When I returned to the States, I was traveling through New York on the way back to Tennessee and I happened to read an issue of the Wall Street Journal. There was a large box of white space on a page that included only these words: “It’s not creative unless it sells.”
As you think about getting your business ready for sale, remember that “SELL is not a four-letter word!” Write that one down and remember it. You’ll find it a helpful reminder as you spend time with your customers and employees.
The bottom line of the A in READY is that in terms of Attitudes, Aptitudes, and Activities, we need to be focused on having our people in the right places doing the right things over time.
The D in READY Stands for Driving Growth
Recall again the basic valuation equation:
Value = CF / (R – G)
It should be clear that there is a direct relationship between growth and value (because raising G with a negative sign decreases the denominator which increases value). Generally speaking, the more rapid your company is expected to grow into the future, the more favorably buyers will look at your prospects and reflect those expectations into their pricing.
Recall the familiar saying: “Rising tides lift all boats.” Sometimes companies find themselves in industry conditions or individual circumstances where, for periods of time, growth seems easy, or relatively easy. That’s wonderful when it happens to you. Do everything in your power to maintain that momentum. But don’t fall into the trap of believing you are really good when it is the rising industry tide that is lifting your boat. It will be that much more difficult to adapt when the tide goes out.
Unfortunately, most business do not find themselves in a situation where growth seems easy. So how do we drive growth when the tide isn’t rising? Here are a few things to think about.
Make growth an intentional goal. Companies grow through tougher times because their managements are intentional about growth and stay focused on that goal. Growth does not happen for most businesses absent conscious decisions on the part of the owners and/or key managers.
Understand your marketplace. What is going on in your marketplace? Read widely and learn about your marketplace and how your company can better relate to the opportunities that arise in it. Talk to a wide variety of people in your industry and across others, as well. Make opportunities to talk to others. Attend trade shows where you have random opportunities to see the unexpected. These opportunities may provide insights or trigger your thinking in your own business. Always be in a process of networking within your industry associations and talking to people about your marketplace. Growth is all about being outbound, and it is surprisingly easy for many business owners to become insular, which is the death knell of growth.
Focus on customer needs and customer service and customer profitability. Recall the old adage of business success: “Find a need and fill it.” Your customers have needs and you will grow by satisfying those needs. At the margin, this means recognizing emerging needs and satisfying them before your competitors do. Customer service is king. Is your business focused on customer service at every point of contact, from initial calls, to returning calls, to simply thanking customers for their business. Customer profitability is also important. In most businesses, a disproportionate share of revenues and profits come from a relatively few customers. Are you doing business with enough of the kinds of customers that can provide good profitability and therefore drive growth?
Make technology work for you. Technology is important in nearly every area of most companies. Are your products and services current, up-to-date, and reflective of customer expectations? Are your services delivered using current technology? Technology impacts how services are delivered and how your services are perceived by customers and clients. I’ve had an expression for years that we want to be on the leading, but not the bleeding, edge of technology in our business. Where are you?
Be intentional about hiring and retaining the best people. A business cannot grow without the right people doing the right things over time. Investing in people is won’t guarantee that your business will grow, but not investing will virtually assure that it will not grow. Don Hutson, a nationally known motivational speaker and trainer, tells the story of an executive who asked this question in the process of initiating a significant sales training program. “What if we spend all this money and they leave?” Don’s response was simply this: “What if we don’t and they stay!” Hire the best people you can find, train them and retain them.
Growth is important for all businesses. Not only does profitable growth enhance business value, but it rejuvenates and energizes companies and their people.
The Y in READY Stands for Year-to-Year Comparisons
Most businesses generate financial statements on at least a monthly basis, very often on a quarterly basis, and always on an annual basis. Financial statements are generally produced for key subsidiaries or divisions, and on a consolidated basis for complex organizations.
Companies also produce operational statements tracking key aspects of their operations, including year-to-year sales, product and customer profitability, branch profitability, as well as statements measuring various aspects of flow-through and productivity.
In other words, the typical business generates a lot of numbers. Years ago, I was assistant treasurer at First Tennessee National Corporation, now First Horizon. My boss and mentor was the bank’s CFO, Bob Rogers, an astute businessman and keen financial analyst. Bob told me on many occasions, “Chris, you’ve got to talk to the numbers until the numbers talk to you.” It took me a while to understand what he meant. The numbers of a business are the summary representations of the activities of the business, and the best measure of the results of those activities, as measured in a variety of ways.
So I learned that a good analyst could, in many instances, understand, or at least make educated guesses, about what has actually happened in a company historically because of the way that those activities are represented in its financial statements.
For example, I was once asked to perform a blind analysis of a bank with no contact with its management. I was able to describe for my clients what had happened, as well as to describe the management philosophy and style of the bank’s CEO. How could I do that? Well, the numbers talked to me. The point is that your numbers can talk to you – and if not you, then to trusted members of your management team and/or advisers.
Three important ways to look at any company are first, at a point in time. A second way is to look at the business itself, over time And third, look at the business relative to peer groups. I expand on this in a post describing seven ways investors look at any business.
Too often, business owners and managers fall into the trap of looking only at the most current financial and operating statements. That will tell what things look like at a point in time, and likely, at the same point in time last year, but that Is not enough.
Trends are of critical importance in your business. Rest assured that when buyers look at your business, they will look at more than the current period, whether this month, quarter, or year. They will look at your historical performance in a variety of ways. Importantly, they will be looking at the past to provide a window through which they can gauge the prospects for expected future cash flow.
The short point of the Y of READY, Year-to-Year comparisons, is that the record of your business, the one that you and your shareholders live with every quarter, is being created right now. At a future point in time, when you are ready or need to sell, buyers will be looking at the record you have created up to that point in time. It is that record that will help set the expectations for the future they can envision with your business.
So the Y of READY is designed to help keep in mind the trends that are being established in your business, both financially and operationally, as you manage the business month-by-month, quarter-by-quarter, and year-by-year.
Good results, being defined as steady progress, consistent margins, strong productivity, and growing earnings do not happen by chance alone. Management is all about making results happen.
The concept of year-to-year comparisons will help keep you focused on the key trends that impact, not only the value of your business and its attractiveness for sale, but also the fun and pleasure that can be derived from building a growing, successful business.
Is Your Business Ready for Sale?
“Is your business ready for sale?” is a question that is important for your business and its owners. Reasons for insuring that your business is constantly READY, or in the process of becoming READY for sale include:
- Companies that are READY for sale are more valuable than similar companies that are not.
- You never know when you might be approached by an enthusiastic, or better yet, a motivated purchaser. If that day comes unexpectedly, you definitely want to be READY for sale.
- A company that is READY for sale is also ready to engage in leveraged repurchase transactions that provide liquidity for some owners and enhanced returns for others.
- A company that is READY for sale is capable of engaging in a leveraged dividend recapitalization, as well, to provide liquidity and diversification opportunities for all shareholders.
- Companies that are READY for sale are also just more fun to work in than those that are not.
So, my final question for now has to be: Is Your Business READY for Sale?