The Shift From Operational Planning to Exit Planning
Will my company sell? This question is frequently posed by small business owners who see retirement, or some other catalyst for succession, on the horizon. It’s an important consideration given the implication on the owner’s liquidity and personal financial planning, yet it’s one that can often sneak up on business owners. Most founders we speak with are adept operators who are devoted to the successful delivery of a product or service, but the thought of positioning a business for sale has never been at the forefront of their planning. According to a recent survey of investment bankers and brokers, more than half of small business owners do not complete planning prior to a sale process.
The attributes of a business that are likely to bode well for a sale will vary depending on acquirer type. A high net worth individual with business operations experience and who is looking to acquire and operate a business will look for a very different set of attributes than the middle-market private equity fund that seeks to deploy $30 million of equity per investment. Before beginning a sale process, it’s important that a seller has transaction goals in mind so that alignment can be created with a specific buyer type. For instance, does the owner want to step away from the business a few months after a sale, or perhaps continue operating the business into the foreseeable future after selling a portion of the business?
Although the particular goals of a seller may dictate the type of buyer that’s best for a sale process, there are a common set of considerations that will be relevant across buyer types. Here we’ll cover three common blockers to a successful business sale.
1. A Lack of Management Depth is a Risk
Depth of a management team is an important consideration for an owner contemplating a business sale. Businesses that are well positioned for transition have often done an excellent job building a high functioning management structure and empowering a team to own key decisions across the business’s operating segments.
Experienced general managers or vice presidents who oversee operations, plus key members on the finance, accounting, and planning side of the business, may represent a group that keeps operations humming through an ownership transition. If management structure needs to be addressed it can be difficult to suddenly remedy a lack of depth in preparation for a sale, so owners should be thoughtful about this step well in advance of beginning a sale process.
Without Managers, Sellers May be Asked to Stick Around
As an example of the risk related to lack of management depth, a transportation and logistics business that desired to be sold had a thin management structure and struggled to overcome this dynamic when exploring a transaction with strategic buyers, the company’s desired acquirer. The business was well regarded for quality service delivery, had a proprietary software application used to manage operations, showed strong revenue and profit growth, and operated in a geography with strong economic trends.
But the business had gone through multiple general managers in the two years leading up to the sale. Although at the time the sale process commenced the then general manager showed signs of settling into the role, prospective acquirers expressed concerns about the stability of management. To offset this risk, one prospective acquirer requested that one of the three founders stay with the company post-transaction and become a full time employee of the acquiring company. This request was not consistent with the goal of the sellers, and the lack of desire among the founders to join the acquiring company resulted in the buyer walking away from the deal.
2. The Owner Should Not Be The Product
In addition to management risk, another example of key person risk relates to the nature of a company’s product and the owner's connection to customers. If a product or service is not proprietary and if the owner is the key relationship holder with customers, then the business may be deemed high risk for customer churn by prospective acquirers.
A Book of Business, Versus a Business
Wealth management practices, which have been recent targets for consolidation, are a good example of a business for which key person risk is applicable. A hypothetical wealth management firm with six employees and $200 million of assets under management (AUM) may generate $1.3 million of annual revenue, or 65 basis points of AUM. Once the firm pays operating expenses it’s left with an attractive 30% EBITDA margin, producing $400k of annual cash flow to the owner.
Of the six employees at the wealth firm, just one, the founder, has regular interactions with the firm’s clients and prospects. The remaining employees conduct market research, support the firm’s administrative functions and help with regulatory and compliance functions. The question a prospective acquirer will ask is whether the wealth firm represents a business, or a book of business. In the absence of the owner’s involvement, can the firm continue to acquire new customers while retaining the existing clients? Or if the founder is no longer affiliated with the firm will the revenue growth engine stop, with some portion of the current customers churning?
If the latter is true, acquirers will deem this to be a book of business, rather than a business. Valuations will differ materially in these scenarios, and the certainty of roles for the employees of the wealth firm may be in doubt given the practice will be folded into an existing platform that has operating functions for compliance, market research and administrative tasks.
The key takeaway is that the best acquisition candidates will function well without the owner at the helm. Not because the owner isn’t bringing value to the company, but because the owner put in place the right structure to create a sustainable operation that continues to produce value under a new owner.
3. Preparing Financial Records For a Sale
One of the clearest ways to show the value of a business is with clean financial records. Sellers should be prepared with at least three years of historical statements across three financial statements – the income statement, balance sheet and cash flow statement. A business that has clean accounting records conveys a level of professionalism to prospective acquirers that bodes well for setting the stage for an earnest discussion about the business. Businesses with poor records, on the other hand, may be discounted by investors who doubt the professionalism of the business, or worse who poke holes in the sources of value that an owner alleges to be of consequence in the transaction.
Although financial record keeping lacks the luster that product or sales oriented functions possess, it is a critically important component of the sale process. The accuracy of financial statements has implications on how the business is analyzed by investors and the level of cash flow that the business is deemed to produce. If a company has not prioritized an accounting foundation that produces clean records, it is not advisable to go to market until these records have been carefully investigated and adjusted to accurately reflect the performance of the business.
Never mind the judgment from a prospective acquirer, as a business owner, staying close to accurate financial performance is not just important for a sale process, it’s critical for strategic decision making and to assess the productivity of cash deployed into operations. Operating a business without clean financials is fraught with risk. Just as management depth is a clear indication of the maturity of an operation, so too is the clarity of the financial picture afforded by a company’s records.
Valuation Expectations are Also at Stake
A solid accounting foundation will reduce the odds that significant changes must be made to the firm’s accounting records to prepare for a sale. Not only do these changes represent the potential for expensive and time consuming work, they could affect the level of cash flow reported by the business. If cash flow is overstated in the firm’s financials, owners may set their valuation expectations at unrealistic levels, jeopardizing the likelihood that a deal is done at a valuation deemed fair by the seller.
For businesses with multiple operating segments, segment level financials are desirable. Consolidated financials tell an incomplete story about sources of growth, cash, and customer retention. A sophisticated buyer is likely to seek detailed segment level financial data to glean insights into the quality of revenue by product, revenue growth rate by product, gross margins by product, cash flow by product and so forth. Owners too should desire this information during the course of operations so that allocations of capital to the business can be made in the highest yielding manner.
Will Your Business Sell?
Business sales are complex and there is no guarantee that a transaction will be successful. But owners can take steps to put the odds in their favor, and are wise to do so in advance of beginning a sale process. In addition to the considerations above, we note that trends in revenue growth and profitability are also important factors in determining the appeal of a business to an acquirer. For more information on this topic, readers can navigate to a post specifically on fundamental and economic considerations relevant to business sales.
When the time comes to contemplate succession, sellers may wish that advanced planning had been completed to prepare for a sale. Rather than finding the sale process to be an exercise in scrambling to complete last minute planning, it’s advisable for sellers to put in place management depth, ensure the transferability of customer relationships, and to invest in financial record keeping to provide an accurate view into the performance of the business.
