An Entrepreneur’s Guide to Understanding Business...

An Entrepreneur’s Guide to Unlocking Business Value Al Danto

1

AnEntrepreneur’sGuidetoUnderstandingBusinessValuation

Table of Contents

Introduction................................................................................................................................2

TheEntrepreneurs’Dilemma.....................................................................................................4

ValuationBasics..........................................................................................................................5

RelativeValue.............................................................................................................................7

RiskAversion..............................................................................................................................9

ExternalRiskFactors.................................................................................................................13

IndustryConditions..................................................................................................................16

SupplyofBusinessesontheMarket.....................................................................................16

InterestRates.......................................................................................................................19

OtherExternalRisks.................................................................................................................21

Internal“CompanySpecific”RiskFactors.................................................................................24

OwnerDependency..............................................................................................................26

HighlyConcentratedCustomerBase....................................................................................27

PoorOnlinePresence...........................................................................................................28

RevenueModel....................................................................................................................29

LackofaClearVisionandDirection.....................................................................................31

NotMaintainingGoodFinancialandCorporateRecords.....................................................31

KeyEmployeeswithoutNon-CompeteorNonSolicitationAgreements.............................33

NotKeepingupwithChanges..............................................................................................34

NotUnderstandingFinancialRatiosandRelativePerformance...........................................36

OverlyAggressiveExpenseDeductions................................................................................37

ImpactofTaxes....................................................................................................................39

AssignabilityofContracts.....................................................................................................40

Notoptimizingtheuseofcapital.........................................................................................41

NotProtectingIntellectualProperty....................................................................................42

SupplierDependency...........................................................................................................43

EntrepreneurialBurnout..........................................................................................................45

FreeCashFlow.............................................................................................................................46

PullingitAllTogether:AssessingValue......................................................................................47


2

Introduction Whenthetimecomestocashinonalltheyearsofhardworkandchallengesofrunningabusiness,mostentrepreneurssimplyassumetherewillbeabuyerwaitingattheendofthejourney—someonewhounderstandsthetruevalueandpotentialofthebusinessandwillofferenoughmoneytosendtheentrepreneurintoretirement,happilyeverafter.Unfortunately,andfartoooften,thisisnotusuallythecase.

Inordertomaximizevalue,entrepreneursmustunderstandhowbusinessvalueisderived.Asmanyfindouttoolate,theviewpointofaninvestorismuchdifferentthanthesellerastheinvestoriscomingfromtheoutsidelookingin.Despitealltheyearsofrunningabusiness,manyentrepreneursnevertakethetimetolearntheconceptsofbusinessvaluationanddevelopaplanthatmaximizesthevalueoftheirbusiness.Notunderstandingbusinessvaluation,andthekeysthatmaximizebusinessvalue,cancostanentrepreneur

significantcapitalwhenthetimecomestocashinonalltheyearsofrunningabusiness.

Itispainfultoseehowoftensimpleandeasy-to-learnconceptsandstrategies,thatcouldhaveaddedsignificantvaluetothecompany,werenotknownorunderstoodbytheentrepreneur.Itissimplyan“unknown,unknown”andinmy30+yearsofentrepreneurshipandteachingentrepreneurs,the“unknown,unknowns”areusuallythemostdamagingtotheentrepreneur.Ispentthefirsthalfofmybusinesscareeracquiringprintingcompanies.Ihadasimplephilosophy—acquirethemascheaplyaspossible,closethedoors,andconsolidatethemintoourexistingoperation.Likethecompanythatofferstobuy“UglyHouses,”myobjectivewastofindreasonstoacquirecompaniesatsignificantlyreducedvaluations,andtherewasnoshortageofprospects.Whenacompanyhadunmitigatedrisks,problems,ortheownersimplydidn’tplanandprepareforanexit,weboughtthematadeepdiscount.Itwaseasytoturnthesecompaniesaroundbysimplyclosingtheirdoorsandrollingthemintoouroperation.Likethegrimreaper,mycompany,oracompanywithasimilarbusinessstrategy,becametheonlyexitoptionforthesebusinesses.WhileIhadyettohaveanyacademictraininginfinanceandbusinessvaluation,Ilearnedthefundamentalsofbusinessvaluationthroughthisexperience.Bylookingathundredsofprospectivecompanieswithmyowncapitalontheline,Iintuitivelylearnedtovalueabusiness.Whilemystrategywastofindundervaluedbusinessesandconsolidatethemintomyoperation,otheracquirersboughtprintingcompaniesthatcommandedahigherpriceinthemarket.Despitethefactthat


3

thesebusinesseshadsimilarcharacteristicsincludingindustry,size,numberofemployees,geographiclocationandanumberofotherfeatures,therewasawiderangeofvalue.Somebusinessescouldcommandahigherpriceandotherssoldforwhatevertheycouldget.WhileIhadnoformaltrainingorframeworkforvaluingabusiness,overtheyearsandcourseofdoingthis,Iknewwhenabusinesscouldbepurchasedforapriceandtermsthatfitourstrategyandbudget.Inhindsight,Ilearnedtoswimbygettingthrowninthewater.WhatIdidn’tknowatthetimewasthattherewasatheoreticalbasisandprocessforwhatIwaslearningonmyown.Therewas,infact,awholesubsetoffinancethatwasdedicatedtobusinessvaluation.Afteryearsofacquiringandbuildingthebusiness,Isoldthecompanytoaprivateequitygroup.ItwasonlybyintuitionandalittleluckthatIexitedthebusinessjustbeforeamarketandpermanentindustrydecline.Ithenhadtheuniqueopportunitytogobacktoschool,obtainanMBA,andgoontocompleteadditionalworkinthefieldofbusinessvaluation,receivingaCVA(CertifiedValuationAnalyst)designation.Iwasabletolearntheacademictheoryandputaformalprocess,framework,andfinancialdisciplinetowhatIlearnedonmyown.AsIputterms,definitions,andconceptstomyyearsofexperience,itwasveryaffirmingtorealizethatIhadactuallydevelopedaverysolidunderstandingofthevaluationprocess.Icouldnowsupportandcommunicatemyintuitiveunderstandingwithprovenandacceptedconceptsandprocesses.Inessence,Ihadlearnedtheartfirstandcamebacklatertolearnthesciencebehindit.Entrepreneursandinvestorsbegantoreachouttomeforadviceonbuying,selling,andvaluingbusinesses.Ialsobegantoteachclassesandworkshopsand,severalyearsago,joinedthefacultyattheJonesSchoolofBusinessatRiceUniversitywhereInowteachcoursesonbusinessstartupandbusinessacquisitionandvaluation.Thisbookisacombinationofmy30yearsoflearningthe“art”bybuyingandsellingcompanieswithmyowncapitalandthe“science”learnedinmyformalstudiesoffinanceandvaluation.Mygoalistohelpentrepreneursunderstandtheimportanceofbusinessvaluationandteachboththeunderlyingfundamentalsandpracticalstepsittakestomaximizethevalueofabusiness.Thisisthe“IwishIwouldhaveknownthenwhatIknownow”practicalstepstobusinessvaluation.AlDanto


4

The Entrepreneurs’ Di lemma

Successfulentrepreneurshavetheuniqueabilitytocreate,grow,andbuildcompanies.Theyadaptandthriveinaworldofuncertainty.Theyhavetheskillsrequiredtoturnanopportunityintoareality,typicallywithinachaoticenvironment.Whilethestart-upandgrowingcompanyoperatesinaconstantlychanging,dynamicenvironment,valueismostoftenincreasedbyconsistencyandpredictability.Thisconsistencyistypicallyderivedthroughdefinedprocessesandcontrols.Theentrepreneurwhostartsabusinesstogetawayfromthesechainsofbureaucracyisnowinchargeofimplementingthem.Thisisnotagoodmatch!Astheburdensofadministrationincrease,theentrepreneurbeginstolosethedriveandpassionthatmadehimsuccessfulinthestart-upandgrowthphases.Thejoyandpassionofbuildingacompanytransformsintothedrudgeryofmanagingit.Iftherightstepsarenotputintoplace,thebusinessstaysinachaoticstate,andthisultimatelyreducescompanyperformanceandvalue.Withoutanunderstandingofbusinessvaluationandalong-termplaninplacetobuildvalue,theentrepreneurwilloftenstartmakingshort-termdecisionsthathurtlong-termvalue.Asthedriveandfocustobuildthecompanybeginstowane,theentrepreneurstartstoputpersonalneedsaheadoflongtermgrowthopportunitiesforthecompany.Insteadofreinvestingprofitsandtimebackinthecompany,theentrepreneurstartsspendingmoretimeawayfromthebusinessandprofitsaredivertedtobuildretirementaccountsorusedforpersonalneeds.Asthepassionrunsout,risktolerancelevelschangeandentrepreneursemotionallycheckoutfromthebusiness;consequently,businessvalueisdiminished.Thesameskillsthatcreatedanddrovethebusinesstosuccessarenowdestroyingthevalueofthebusiness.Inordertomaximizevalue,entrepreneursmustunderstandthefundamentalsofbusinessvaluationandequally,ifnotmoreimportantly,theemotionalside.Theymustknowwhentogetoutandhowtoget

out.


5

Valuation Basics

Asa28yearoldentrepreneur,whatdoyousaywhenyouhaveashottobuyoutyourlargestsupplier?StewartandSullivanhadbeenavendorofmyprintingdistributorshipsincestartingthecompanythreeyearsearlierinmyapartment.TheywereoneoftheoldestprintingcompaniesinHouston,andthechancetoacquirethemwasagreatopportunity.Despitethefactthatwehaddevelopedacloseworkingrelationship,Iwonderedwhatunknownskeletonswouldpopupifweboughtthecompany.Wouldemployeesstay?Wouldcustomersleave?Wouldtheequipmentbreakdown?Weretheirbooksaccurate?WasIpayingtoomuch?DidIassessallthepotentialrisks?Whiletheopportunitytobuythecompanylookedgreatonpaperandinstrategy,itwasverydauntingandunnervingtothinkabouteverythingthatcouldpossiblygowrong.Theserisksandfearsresonatedinmygut.Withnoformalunderstandingofbusinessvaluation,Iwasdoingwhateverybusinesspurchaserandinvestordoes—tryingtopredictthefutureofthebusinessandrelatethattotheriskofachievingtheoutcome.Afteracquiringbusinessesforover30years,Inowknowthat“fear”ispresentwitheverypotentialbusinessbuyer.


6

Businessvaluation,atthecore,issimpleandbuiltontopofthisconcept.Mosteducationalmaterialonbusinessvaluationfocusonthetechnicalanalysisofnetincomeorcashflow,discountsratesorsometypeofmultipleorreturnonthiscashflow.Despitethisbeingthetypicalstartingpoint,Ihaveconcludedinmy30yearsofexperiencethatriskisthetrueunderlyingdrivingfactorofbusinessvaluation.Iwillleavethediscussionandcalculationofcashflowtotheendofthebookuntilyouhaveafirmunderstandingofthedrivingforcesthatimpactthevalueofthesecashflows.Ultimately,lowerrisk,andaclearerfuture,equalsahighervalue.Intheformalstudyofbusinessvaluationandfinance,thoserisksareidentified,quantified,andvalueiscalculatedinoftencomplexfinancialmodels.However,underneaththecomplexformulasandfinancetermsliesafundamentallysimpleconcept:Businessvalueisbasedonthefutureexpectedperformance(CashFlow)ofabusinessdiscountedforthecorresponding“Risk”(Fear).Insimpleterms,youmustreducethe“fear”oftheunknownthateverypersonconsideringinvestingtheircapitalinyourbusinesswillhave.Whilethisseemsextremelysimple,itproveschallengingformostentrepreneurstograspwhenitcomestotheirbusiness.Mygoalistodemystifythevaluationprocess,helpyouunderstandthefundamentalconceptsofbusinessvaluationandarmyouwiththetoolstocreateaplanthatmaximizesthevalueofyourbusiness.


7

Relative Value

Ihavecometorealizethatmostentrepreneurshavenorealunderstandingofbusinessvaluation.Mostsimplythinkthevalueoftheirbusinessisbasedonanindustryaveragetiedtoastandard-likemultipleofearningsorpercentageofrevenue.SometimestheyhearstoriesofwhatsimilarcompaniessoldforintheirindustryorasktheirCPAforanopinion.Basinganestimateofbusinessvalueonaverages,hearsay,orafewdatapointsisextremelyflawed.Whilethisapproachmayworkforassetslikehousesorcars,itdoesnotworkinbusinessvaluation.Therearesimplytoomanyvariablesthatgointoeachbusiness’sspecificvaluation.Withoutathoroughanddetailedanalysisofallthevariablesuniquetothecompany,thereisnowaytoaccuratelyassessvalue.Businessvaluationisthestudyofthevariablesandrisksthatimpactthevalueofacompany.Whenabusinessownersaysthevalueofhisorhercompanyisbasedontheindustryaverageorwhatasimilarcompanysoldfor,mostvaluationanalystscringe.Let’stakeaminutetodiscussaverages,sowecanunderstandhowflawedthisthinkingreallyis.TheaverageheightofanadultmaleintheUnitedStatesisabout5’9”.However,thataveragecanthenbefurtherbrokendownintoanumberofdifferentcategorieswithanaverageandbellcurveforeachone.Youcouldgettheaverageheightofanadultmalebyage,geographicallocation,ethnicity,typeofjob,andsoon.Prettymuchanythingcanbeaveragedandputintoabellcurve.Forexample,youcanaveragenumberofemployeespercompany,numberofchildrenperfamily,numberofshoesperperson,priceofacar,priceofahouseetc.Ifyoucannameit,mostlikelyyoucanaverageit.


8

ThispicturewastakeninFebruary2011,therewas6”ofsnow,anditwas5degrees.IfItoldyouitwastakeninaUScity,youwouldmostlikelyguesssomewhereinthenorthorevenmaybesomewhereinthemountains–right?

Wrong!ThispicturewastakeninDallas,TexaswheretheaverageFebruarytemperatureis59degrees.TravelersarrivingtoDallas,dressedforanaveragetemperature,wouldbeinforabigsurprise.

Justliketemperaturesandmostanythingelse,businessvaluations—eventhosewithinthesameindustrywithsimilarsize,revenue,andprofit—willhaveawiderangeofvalues.Theaveragevalueofabusinessinanyindustryissimplythemiddlepoint.Inordertohaveamiddlepoint,theremustbeanequalnumberofvaluesordatapointsoneitherside.Somewellpointswillbebelowaverage,otherswellaboveaverage,andsomerightnearthemiddle.Whileyoucan’tcomparethevalueofaflowershoptooneofasoftwareormanufacturingcompany,theowneroftheflowershopshouldstriveforhavingthehighestvaluepossiblewhencomparedtootherflowershops.Manyfactors,eachuniquetothespecificbusiness,impactthevalueofabusinessandmovethevalueeitheraboveorbelowaverage.Businessvaluationistheanalysisofthesefactors,risks,alongwiththeirimpacttoabusiness.Anentrepreneurarmedwiththeknowledgeoftheseconceptscandevelopalong-termplanthatcansignificantlyincreasethevalueoftheirbusiness.Withtheknowledgeofthevaluationprocess,anentrepreneurcanbuildabusinessthatisworthsignificantlymorethan“average”andmaximizethevalueofthebusinessandyearsofwork.Theobjectiveofthisbookistohelpentrepreneursandtheiradvisorsunderstandwhatittakestoget

ahigherthanaveragevaluationwhencomparedtootherbusinessesinthesameindustry.


9

Risk Aversion

Entrepreneursmustunderstandthattherisk—eitherrealorperceived—withintheirbusiness,andhowthatriskimpactsthecashflowofthebusiness,isthefundamentaldriverofbusinessvaluation.Whenthisconceptisthoroughlyunderstood,anentrepreneurcanbuildastrategyandtacticalplanthatwillincreaseandmaximizevalue.Thisisthefundamentalreasonwhybusinessesinthesameindustryofthesamesizecanhaveawiderangeofvalue.Takeoutrisk,addclaritytothefutureexpectedcashflows,andtheentrepreneurwillincreasevalue.Riskisatthebaseofeveryvaluationmethodologyandcalculation.Itisassessedfromthebasic,intuitivegutlevelthroughthemostanalytical,complexspreadsheetsandduediligence.Risk,andperceivedriskfromanoutsidepartylookingin,isoften“overemphasized.”Thisoveremphasishasbeenthesubjectofmanystudies.InhisbookTradingtoWin,AriKievsays,“Thefearoflosingmoneyhasmoreinfluenceovertheinvestorthanthedesiretomakemoney.Becauseofthepainofloss,peoplewilldomoretoavoidlossthantheywilltomaximizeprofit.”Thiscouldnotbemoreevidentthaninbusinessvaluation.Investors,acquirers,andvaluationexpertsunderstandthatrunningabusinesshasbothriskandopportunity.However,riskswillalwaysbemagnifiedwithagreaterreductioninvaluethanopportunitywillbeincreasedinupsidevalue.Entrepreneursmustinternalizeandunderstandthisperspective.Thereisnoescapingit.Anyincreasedriskoruncertainty—perceived,real,orpotential—thatisnotunderstoodormitigatedcansignificantlydecreasethevalueofabusiness.Entrepreneursmusthaveanswersandbeabletoshowaplantomitigatetheriskandvariablesthatbuyersandinvestorsfear.Theoptimistic,glass-half-fullentrepreneurmostoftenwronglyassumesthattheupsidepotentialismostimportanttoaninvestor.Don’tgetmewrong,investorswantandwillpayapremiumforabusinesswithpromiseandexcitingupsideopportunity,buttheywillnotdosowithoutfirstunderstanding,quantifying,anddiscountingtheseopportunitiesforthedownsiderisks.Questionslike:

• Whatwillyoudoonceyousellthebusiness?• Whyareyousellingthebusiness?• Willyoustayinvolvedwiththebusinessinsomeway?• Whatdoyouremployeesthinkofthesale?• Whyisthereanincreaseininventory?

Arereallyfearsofriskandmean:

• Whyareyoudumpingthebusiness?


10

• Howfarareyougoingtorun?• Don’tyouhaveanyconfidenceinthefutureofthebusiness?• Areemployeesgoingtojumpshipafterthesale?• Areyoulosingcustomersandsales?

Entrepreneurswhounderstandandminimizedownsidefears,bothrationalandirrational,willbegin

tosignificantlyincreasethevalueoftheirbusiness.Hereisoneofthebiggestchallengestotheentrepreneur.Havingrunthebusinessforyears,theentrepreneurbecomesimmunetotherisksimbeddedinthebusiness.Overtime,theowneracceptsandbecomescomfortablewiththem.Let’ssayyou’veownedacarforalongtime,andithasservedyouwellfor50,000miles.Youprobablyviewthecarasdependablebecauseitstartseverytime;youhavenofearthatitwillbreakdown.Toyou,theowner,thetimeandmilesareacomfortfactor.Buttheviewpointandperspectiveofapotentialbuyeroroutsidepartyiscompletelydifferent.Thecar,orbusiness,isanunknown,andthebuyerwillassumeandfeartheworst.Isitalemon?Whatproblemsarethere?Willitleavemestranded?50,000isalotofmiles!Ahighlyregarded1979studyentitled“ProspectTheory,”byNobelPrizerecipientDanielKahnemanandhispartnerAmosTversky,concludesthatinvestorsareindeedirrationalwhenassessingthepotentialforlossovergain.Inordertoavoidlosingmoney,investorswillseekoddsthataremanytimesgreaterthantheriskoflosing.Forexample,whenflippingacoin,mostpeoplewillonlyrisklosing$20iftheyhavetheopportunitytomakeatleast$40.Despitethe50/50probability,thepainoflosingismuchgreaterthanthepotentialrewardofmakingmoneyevenwhengivenbetterodds.Astheoverallimpactoflosstotheinvestorincreases,sodoesthisirrationalitywhencomparedtonormalexpectationsandprobability.Thedownsideriskcancompletelyoffsetanypotentialgainnomatterhowgreatthepotentialreturnandhowgoodtheoddswhenthestakesgethigher.Toillustratethispointinmyclassroom,Itakeouta$5billfromabankenvelopeandaskstudentswhoiswillingtoflipacoinforthe$5.Atleasthalftheclassisalwayseagertotakemeuponthisbet(whiletheotherhalfalwaysthinksthereissomesortoftrick).Iflipthecoinandcollectorpayoffthewinner.Next,Itakeouta$100billandofferthesamebet.Atthistime,therearetypicallyacouplegun-slingerswhowillstepuptotheplate.IthenraisetheoddsbysayingIwillpay$150towinandonly$100tolose.Despiteincreasedexpectedreturns,onlyafew,ifany,takethebet.

DanielKahneman


11

Nowaddmillionsofdollarsatriskinabusinessacquisition,andyoucanbegintounderstandwhythedownsideriskoflosingismagnified.Thisfundamentalconceptisalwayspresentandwilldriveinvestordecisionsandthevalueofyourbusiness.Youmustunderstandthatrisks,uncertainties,andunknownvariablesinyourbusinesswillresultinsignificantdecreasesinthevalueofyourbusiness.Whilethisseemseasytounderstandfromanintuitivestandpoint,itisextremelydifficultfortheseller

ofabusinesstofullycomprehendwhenitcomestohisorherbusiness.

Risksthatarenotconsideredbytheentrepreneurrunningthebusinesscanbecomemajordestroyersofvaluetosomeoneevaluatingthebusinessfromtheoutside.Therearetwosidestoeverystoryandtwoperspectivesbetweenthebuyerandseller.Asaseller,youhavetoanticipatethebuyer’squestions,concerns,andfears.Seller:“Couldoneofmysalesrepsleaveandstartanewbusiness?Wellsure,butIhaveknownhimandhisfamilyforyears.Wehavebeenthroughthickandthin.It’snotarealrisk.”Buyer:Well,itistoapotentialinvestororbuyer!Seller:“CouldIlosethatkeysupplier?Noway.Weplaygolfeveryweekandhavedonebusinesstogetherforyears.”Buyer:Wellyouknowwhat...Idon’t!Seller:“Nooneinourindustryprovideshealthinsurance.”Buyer:Yes,well,whatabouttheimpactsoftheAffordableHealthcareAct?Buyer:Aren’tyouintheGulfCoast?Couldn’ttherebeaHurricaneanyyear?Seller:Yes,sowhat!Buyer:Youdon’thaveawrittenemploymentguide?Seller:“Whyshouldwe?”Buyer:WhatabouttheFairLaborandStandardsAct?Fromtheoutsidelookingin,anyoneofthesefearsisareasontodiscountthebusinessvaluation.Mitigatingrisk,anticipatingquestions,andansweringfearsincreasesvalue.Anyonefromtheoutsidelookingin—beitaninvestor,banker,buyerorvaluator—looksatriskanduncertaintywithmuchmorecautionandskepticismthantheentrepreneur.Beforeanyrosyprojectionsoropportunitiesareconsidered,outsidepartieswilllookatthedownsideriskfirst.Itisonlyaftergettingcomfortablewiththedownsideriskthattheywillconsidertheupsidepotentialwithmoreoptimism.

Entrepreneursmostoftenleadwiththeupsidepotential,butoutsideinvestorsalwaysstartwiththe

downsideriskfirst.


12

Whileallrisksinabusinesscannotbemitigated,theymustbeclearlyunderstoodbytheoutsidepartyevaluatingthebusiness.Youcan’tputlipstickonthepig.Allriskswillcomeouteventually,especiallyafterathoroughandexhaustiveduediligenceprocess.Eveniftheydonotgetuncovered,thereisthepotentialofalawsuitifnotdisclosedanddiscoveredlater.Outsideinvestorssimplywanttounderstanddownsideriskbeforetheygetexcitedandlookatupsidepotential.Valueismaximizedbyfirstdecreasingdownsideriskandthenbyincreasingthepredictabilityandclarityofthefuture.Itisonlyoncethisdownsidefearoflossismitigated,thatthepotentialupsidewillbefullyconsidered.Don’teverforgetthis!

Someriskfactorsareoutsideoftheentrepreneur’scontrol,butmanymorearewithinthecontrolandinfluenceoftheentrepreneur.Theobjectiveoftheentrepreneurandtheexitstrategyistodevelopaplantominimizeinternal,controllableriskfactorsandbeawareofoutsideriskfactors.Whileexternalriskfactorscan’talwaysbecontrolledoreliminated,decisionscanbemadeinregardtotimingandstrategiesputinplacetohelpmitigatethem.Aformalvaluationfollowsastandardprocessthattouchesonmosteverypotentialriskfactorthatcouldimpactabusinessanditscashflow.Analystsquantifytheserisksincomplexformulasandultimatelyvalueisdeterminedbydiscountingthecashflowofthebusinessbytheseriskfactors.Potentialbuyersandinvestors,whoareputtingtheirownmoneyatriskwithoutcompletingaformalvaluation,willbecautious,thorough,andskepticalfromanintuitiveorgut-basedprocess.Oftentheseexperiencedbuyerswillbemoreintunewithundueriskthanthemostindependentvaluationanalystwillbeinaformalanalysis.Armedwiththeknowledgeofthevaluationprocessandtheunderstandingthatinvestorswillirrationallyassessdownsiderisk,entrepreneurscangetastepaheadbycreatingalong-termstrategytominimizerisksandbegintomaximizethevalueoftheirbusiness.


13

External Risk Factors

Withanunderstandingofhowpotentialbuyers,investors,andvaluatorsviewandoverlyfeardownsiderisk,wecanstarttobuildaframeworkandstrategyaroundthisconcept.Eliminatingandmitigatingexcessriskwillbecomethebasisforcreatingaplantomaximizevalue.Therearebasicallytwomaincategoriesofrisk:externalandinternal.Externalrisk’simpactcannotbecontrolledbytheentrepreneurwhileinternalrisk’sfallsunderthecontrolandinfluenceoftheentrepreneur.Informalfinanceterms,externalrisksarereferredtoassystematicoraggregaterisks.Theyarerisksthatimpacteverybusinessandcannotbechangedbytheentrepreneur.Internalrisksarecalled“CompanySpecific”andfallunderthecontrolandinfluenceoftheentrepreneur.Thinkofexternalriskfactorsasthetide.Whenthetidecomesin,allboatsrise;whenitgoesout,allboatsgodown.Whilethereisnotmuchthatcanbedonetostopanincomingoroutgoingtide,entrepreneursmustrealizethatthetimingofthesefactorswillimpactvalue.Thesefactorsinclude:

• TheNationalandLocalEconomy• IndustryConditions• Supplyofbusinessesforsale• Interestratesandavailablecapital• MiscellaneousexternalfactorslikeTechnology,Labor,Political,CivilUnrest,Weather

Tounderstandexternalrisksconceptually,thinkaboutthefinancialcrisisof2008–2009.Thisimpactedmosteverybusinessasitwasimpossibletoescapetheeconomicdownturnanditsimpacttovalue.Businessownerswhohadtosellduringthesetimestypicallysoldatmuchlowervaluationsthanthosethatexitedbeforeorafterthedownturn.Externalorsystematicrisksarethe“when”orthetimingaspectoftheprocess.Thecontrolofthese

risksismostoftenoutsidetheentrepreneur’sinfluence,butthetimingisoftennot.Whiletheseaggregateriskscan’tbechangedoravoidedbytheentrepreneur,valueisincreasedwhentheserisksareattheirlowest.Themorecomfortableinvestorsarewiththeeconomyandreportsregardingtheemploymentsituationandeconomicoutlook,themorewillingtheyaretospendtheircapitalandmakeinvestments.Thisiswhyreportssuchasconsumerconfidenceandnationalemploymentnumbersaresoimportant.Thesereportshaveaclearandimmediateimpactonpubliclytradedsharesofstock.Investorsandanalystseagerlyawaittheirreleaseandtheresultsgreatlyimpactthevalueofpubliccompanyshareseveryday.Whilenotasimmediateandevident,thesameistrueforsmallprivatelyheldbusinesses.


14

Therosiertheoutlookoftheoveralleconomicsituationandforecasts(national,industry,andlocal)themorewillingbusinessesaretoincreasehiring,makeinvestments,andspendmoney.Thetideiscomingin,andmostbusinessvaluesarerising.Aninvestororbuyerofabusinesssimplyhasmoreconfidenceinbettertimes.Itisnotdifficultfortheentrepreneurtounderstandthat“perceived”valueincreasesduringgoodeconomictimes.However,thechallengemostoftenistorealizethatthisistypicallythebesttimetoexitthebusinessandmaximizevalue.However,sellingduringgoodtimesishardandespeciallychallengingfortheoptimisticentrepreneur.Timesaregood,demandishigh,andprofitsaregrowing,sowhysellnow?Itisonlygoingtogetbetter.Althoughcounterintuitive,therearemanyreasons,frombothanemotionalandtechnicalstandpointwhysellingduringgoodeconomictimesisthebesttimeforanentrepreneurtoexitthecompany.Fromatechnicalvaluationstandpoint,trendlinesareusedtosupportprojectionsforthefutureperformanceofabusiness.Afterafewgoodyearsinarisingeconomy,investorsandbusinessbuyerswillbuyintothefuturewithmoreconfidenceandrewardtheentrepreneurwithahighervaluation.

Whileeconomicconditionsimpactallbusinessestosomedegree,specificbusinessesareimpactedmorethanothers.Forexample,businessesprovidingproductsandservicesthatarenon-essentiallikeluxurygoodsandserviceswillbeimpactedevenmore.Theircustomersspendmoreingoodtimesandalotlessinbadtimes.Somebusinesseslikeautorepaircompaniesmayactuallyincreaseinvalueduringtoughereconomictimes.Entrepreneursmustbeawareandunderstandhowoveralleconomicsituationswillimpact

theirbusinessvaluation.IstartedbuyingprintingcompaniesinHoustonduringthemid1980’s.TheHoustoneconomywasextremelydepressed.Manyprintingcompaniescomingofftherecentenergyboomwerenowbarelyabletocovercostsandkeeptheirdoorsopen.


15

Thesesamecompanies,thatonlyyearsbeforewererunningshiftsaroundtheclockandchargingpremiumprices,werehappytotakevirtuallyanyofferthatwouldgetthemoutofthebusinessandtheirchokingoverheadthatwasbuiltupduringtheprecedingboom.WhileIdidn’tunderstandthefirstthingaboutformalbusinessvaluationortheimpactofeconomicconditionsonbusinessvaluation,IfiguredoutprettyquicklythatIcouldpickupbargainsduringthesetougheconomictimes.Houstonbusinessownerswhosoldduringthegoodtimesafewyearsearlierreceivedsubstantiallyhighervaluationsthenthosewhowaited.


16

Industry Conditions

Likethenationalorlocaleconomy,anindustrythatistrendingupwardsisfarmoreattractivethanonethatistrendingdownwards.Atanygiventime,someindustriesaremovingupwhileothersareheadingdown.Currently,popularindustriesareconsidered“Hot”andoutoffavorindustries“Cold.”Entrepreneursmustunderstandhowindustryconditionsareimpactingthevalueoftheirbusinesses.Someindustriesarealsoconsideredmoreriskyinnatureduetoanumberoffactorsincludingregulations,fads,cyclicality,andotherrealandperceivedissues.Theseindustrieswillreceiveahigherriskpremiumandalowerrelativevaluation.Apositiveexampleofthismaybefederalorstatetaxsubsidiesextendedtoenergyefficientcarmakerstohelpreducecarbonemissions.Thesubsidiesallowforthesecompaniestobenefitinavarietyofways,suchasincreasingprofits,loweringpricestocompetewiththetraditionalcarmakesandmodels,andincreasingR&D.Ontheoppositeend,anticipatedindustryregulatorychangescanhavesignificantnegativeeffectonanindustry.Inthelastelection,certaincandidateswereinfavorofradicallysimplifyingthetaxcode.ThiswouldsignificantlyimpactthevalueofCPAfirmsandbusinessessuchasH&RBlockandothertaxservicecompanies.IndustryreportsandtheirimpacttocompanyvalueareavailablethroughavarietyofsourcesincludingIBIS,TradeAssociationsandInvestmentBankingfirms.Entrepreneursmuststaycurrentwiththeirindustryandhowitisimpactingvaluation.

Supply of Businesses on the Market

Thesimpleeconomicsofsupplyanddemandofbusinessesforsaleinthemarketatanygiventimesignificantlyimpactvalue.Itisabuyer’smarket,andvaluesaretypicallylower,whenthereisahigherthanaveragenumberofbusinessesavailable.Itisaseller’smarket,andvaluesaretypicallyhigher,whenfewerareavailable.Therearemanyfactorsthatinfluencethesupplyanddemandofbusinessesonthemarket.Oneinterestingconceptthatisoftencounterintuitivetomanyentrepreneursiswhathappenswhentimesaregoodintheeconomy,aspecificgeographicarea,oraspecificindustry.Whentimesaregoodandpricesarerising,sellerswillholdoutthinkingthatthegoodtimeswillcontinuetogetbetter.Iftheyselltoday,theygiveuptheopportunitytosellatahigherpricelater.Conversely,whentimesarebad,theyoftenwanttoselltoavoidagreaterlossinthefuture.


17

Becauseofthisconcept,manyentrepreneursfinditdifficulttothinkaboutanexitduringgoodtimes.Thisresultsinatightersupplyofbusinessesforsaleinthemarketandcandriveupvaluationsfurtherresultinginaseller’smarket.Despitethisfact,manyrationalentrepreneurshaveahardtimelettinggoandtheresultisan“irrationalexuberance”amongentrepreneursduringgoodtimes.Themindsetisthatthingsaregood,I’mmakingalotofmoneyanditwillonlygetbetter,sowhysellnow?Thiscreatesauniqueopportunityfortheentrepreneurwhounderstandsthisdynamic.Ingoodeconomictimes,buyers,investors,andlendershaveanincreasedconfidencetoinvesttheircapital.Thiscoupledwithalowersupplyofbusinessesavailableoftenpushesvaluationstoextremelyhighlevels.LivinginHouston,Texasforthelast30years,Ihavewitnessedthiscycleseveraltimesintheenergyindustry.Themostrecentwasintheyearsleadingupto2014.Theproliferationofhorizontaldrillingandfracking,combinedwithhighenergyprices,resultedin“boom”timesfornotonlytheenergyindustrybutotherstiedtoit.Wecompletedvaluationsandconsultedonanumberofacquisitionprojectsduringthistimeperiod.Onecompanyweworkedwithwasatruckingcompanythatservedtheenergyindustry.Theyhauledoffthewaterandfluidsusedbydrillingcompaniesinthefrackingprocess.Afterseveralgreatyears,theirCPAcalledusinforavaluationofthecompanyfortheownerwhowasapproachingapossibleretirementage.Wecameupwithahighvaluationthattookintoconsiderationthecurrentgrowthrateandstrongmarketconditionsincludingaverylimitednumberofthesetypesofservicecompaniesforsale.Ourconclusionshowedthathewouldgetahigherthanaveragevaluationandwouldhaveseveralcompaniescompetingtoacquirehisbusiness.Hisirrationalexuberancewasevidentinhisconfidentopinionthatitwouldonlygetbetter,andhewasmakingtoomuchmoneytosellnow.Lessthanayearlater,oilpricesplummeted,alongwiththedemandfortheseservicesandthemarketvalueofhiscompany.Now,heisinaveryunfortunatesituationthatmanyentrepreneursfindthemselvesinwhentheymissthewindowtoexitduringmarketexpansion.Asrevenuesanddemandforhisservicesrampedup,theownerincreasedresourcesandcapitalgoodsliketrucks,equipment,andupgradedfacilities.Healsoaddedstaffandtookonmoredebttodothis.Now,heisfacedwithincreasedoverhead,additionaldebtpayments,anddecreasingsales—notagoodcombination.Insteadofexitingatthepeakofthemarketandenjoyingacomfortableretirement,heisfacingbankruptcyandveryuncertainfuture.Whensituationslikethisoccur,theentrepreneurfindshimselfmissingawindowthatcancloseveryquickly.Insteadofsellingforapremium,puttingmoneyawaythatwouldgaininterest,andtransferring


18

theriskofrunningthebusinesstosomeoneelse,theentrepreneursoonrealizesthatheisnolongerontopoftheworld.AmajorfactorthatwillgreatlyimpactthesupplyofbusinessesonthemarketintheupcomingyearsistheBabyBoomergeneration.Theseforty,fifty,andnowsixtyyearoldbusinessownerswillhaveaseriousimpactonthevaluationofprivatelyheldbusinessesastheybegintoexitandretire.AccordingtoBizQuest,wearenowintheinitialstagesofwhatisexpectedtobethegreatestwaveofbusinesstransitionsinU.S.history.At83millionstrong,babyboomersrepresentthelargestsinglesustainedgrowthofpopulationinU.S.history.Thisgenerationstartedandgrewhundredsofthousandsofsuccessfulprivatelyheldbusinesses.TheseBabyBoomerswillvastlyincreasethesupplyofbusinessesavailablewhichisexpectedtoleadtoaglutofbusinessesinthemarket.Thisisexpectedtodrivedownvaluationsandgivenewleveragetobuyers.AsurveybyPricewaterhouseCoopersfindsthatoneoutofeverytwocompanyownersplantoselltheirbusinesswithinthenext10years,andpeople55orolderown30percentofallbusinesseswithemployees.Thesimplefactisthatthiswillresultinanincreasedsupplyanddrivedownoverallvaluations.Historically,mostbusinessownersexittheirbusinesswithlessthansixmonthsofadvancedplanning.Likeanyothermarketwithincreasedcompetition,standingoutfromthecrowdiscrucial.Entrepreneursmustunderstandthattherewillbemoreoptionsandchoicesavailableinthemarketforbusinessbuyers.Inabuyer’smarket,anyissuesproblemsorriskswillhaveanevengreaterimpactonvaluation.Buyersandinvestorswillhavemorechoicesandoptionstochoosefrominthemarket.Iftheydon’tlikesomethingaboutaspecificbusiness,theycanmoveontoanotherone.Justlikeahomeownersellinginabuyer’smarket,whomusttakeextracaretomakesurehishousestandsoutagainstotherlistings,businessownerswillhavetotakeadditionaltimeandpreparationtogettheirhouseinorderbeforeplacingitonthemarket.


19

Interest Rates

Interestrateshaveperhapsthegreatestoverallimpactonbusinessvaluationthananyotherexternalfactor.Entrepreneursmustbeawareofthecurrentinterestrateenvironmentandwhichdirectionratesareexpectedtomove.Thereareacouplecriticalreasonsforthis.Thefirstisthatcapitalforanacquisitionorinvestmentcomesineithertheformofdebt(borrowingfrombankorotherlender)orequity(frominvestors).Increasedinterestratesmeansthecapitalhastobepaidbackatahighercostandacquisitionsbecomemoreexpensivetofinance.Thisimpactsbothdealstructureandvaluations.Lenderslookataratiocalledthedebtcoverageratio.Thedebtcoverageratioistheamountofprofitabovethepayment(principalandinterest)thatmustbepaidbacktothebankeachpayment.Thisistypicallyevaluatedonanannualbasis.Lenderswanttoensurethereisadequateprofitinthebusinesstopaybackallprincipalandinterestpaymentswhentheycomedue.Forexample,ifabankisanalyzingaloanof$1millionforthepurchaseofabusinessandinterestratesareat4%,therewillbe$40,000dueininterestalone.Ifinterestratesareat6%,thatnumberincreasesto$60,000.Abusinesswithnetannualcashflowof$80,000wouldhaveadebtcoverageratio2:1withinterestratesat4%($80,000ofprofitdividedby$40,000ofinterestdue).Thisisamorethanadequate


20

debtcoverageratio;forevery$1ofinterestthatisduetothebank,therewouldbe$2ofprofittocoverit.However,ifinterestratesweretoriseto6%,thisratiowoulddropto1.3:1whichwouldbeunacceptabletomostlenders.Tomakeupthisdifferenceandcreateacceptableterms,lenderswould

requirealowervaluation.Thesecondreasonisthatinvestorswillalwaysseekthebestreturnfortheleastamountofrisk.Inahigherinterestrateenvironment,investorscanputtheirmoneyinothertypesofinvestmentslikebonds,realestate,dividendpayingpubliclytradedstockorotherlessriskyinvestments.Whencomparedtotheseoptions,owningaprivatelyheldbusinessismuchmorerisky.Inahigherinterestrateenvironment,theywillreceiveahigherreturnontheirmoneyfortakinglessriskthaninvestingorbuyingabusiness.Inordertocompensateforthisdifference,investorswillrequireahigherpaybackoragreaterownershipofthecompany,eitherofwhichwillresultinalowervaluation.Anotherdynamictothisisthat,inalowinterestrateenvironmentsuchastoday(early2016),thereismorecapitalavailable.Whenmorecapitalisavailable,lendersareinamorecompetitiveenvironment.Moneyislikeanyothercommodity,andwhenthecostofthecommodityislower,thereismorecompetitionforit.


21

Other External Risks

Otherexternalriskslikethethreatofnewtechnology,labor,governmentregulations,politicalconsiderations,andotherexternalrisksandthreatscansignificantlyimpactbusinessvaluation.Intoday’smarket,theuncertaintyaroundhealthcareregulationhashadaseriouseffectonvaluationsimpactedbythesepotentialrisks.WehavevaluedseveralUrgentCarefacilitiesovertheyears.Historically,thesehavebeenextremelyprofitablebusinessmodelsresultinginveryhighvaluations.However,asinsurancereimbursementsratesdeclineandtheuncertaintycontinuestoincreasearoundthem,valuationsandthedemandforthesebusinesseshasbeenonasteadydownwardtrend.Intermsofvaluation,thesebusinessespeakedafewyearsagoandonlytimewilltelliftheywillevercomeback.Inmyopinion,Idoubtitasthereislongtermdownwardpressuretoreducecostinallareasofhealthcare.Ihavebeenextremelyfortunatetohaveexitedtwobusinessesnearthepeakofthemarketinbothindustries.Thefirstwasmyprintingcompanyin1999,andtheotherwasaninternationalnurserecruitingcompanyin2007.IexitedtheprintingbusinessjustbeforesignificanttechnologychangesdisruptedtheindustryandtherecruitingcompanyjustbeforetheVisaandimmigrationlawsseverallyimpactedthesupplychain.HowdidIdecidetoexitthesebusinessesattherighttime?Inbothcases,therewere—inhindsight—veryobvioussignsofimpendingchange.Ineverymarketpeak,therearesignsthatapeakandimpendingdeclineorcrashisonitsway.However,thechallengeistointerpretthesesignsand,theevenmorechallengingpart,istoactonthem.Fortunesaremadeandlostoncatchingthesesignsormissingthem.IamextremelythankfulthatIdidnotmissthesignalsindecidingtoexitthetwomaincompaniesIstarted.Iwillneverforgetwhenthelightbulbwentoffformewithmyprintingcompany.Themainproductmyprintingsoldweremulti-partbusinessformsthatranthroughacomputerprinter.Weliterallysoldmillionsoftheseformsayear,andoneofourbiggesttargetmarketswasbeveragedistributors.ThebiggestwasAnheuser-Buschbeer.Wesoldourproductstoover500oftheirdistributorsaroundthecountryaswellasotherbeveragedistributorslikeMiller,Coors,Coca-Cola,andPepsi.Wehadsalesrepsandmarketingcampaignsgearedtothisindustryaswellasotherindustriesliketravelagencies,drycleaners,andapartmentcomplexesandothersthatusedanabundanceofthesesametypesofbusinessforms.Inearly1999,Iattendedabeveragewholesaler’sconferencewithmysalesrepinLasVegas.Aisleafteraislewasdevotedtothelatestandgreatestintheindustry.Mostofitwasgearedaroundnewsoftware,


22

thelatesttrucks,equipment,andnewbeverageproductswereintroduced.AsIwalkeddownoneaisle,IsawaverysmallbooththatactuallyhadoneofourBudweiserlogoformsontheirdisplay.Ithadaredcircleandalinethroughit.Obviously,Ihadtocheckitout.Iwalkeduptotheboothandaskedthemwhatproductstheysold.Theysaidtheirproductwasarevolutionaryelectronicsignaturepadthatwouldeliminatetheneedforprintedbusinessforms.Ashardtobelieveasitisnow,thethoughtofnothavinga“hard”copyofasignedbusinessformwitharecordoftheitemspurchasedwastotallyunheardofatthetime.Ourbusinessformsservedasaproofofpurchaseandsignedsignatures,alongwithcopiesforbothpartiesandtheirvariousdepartments,wereacriticalpartoftheiroperatingprocess.Thiswasaproductthatcouldneverbereplaced.However,thatnightsomethingresonatedwithme.ThiswasjustanothersignofthedisruptivetechnologythatIhadbeenseeingallaroundme—highspeedcolorcopiers,theInternet,andnowthepotentialforelectronicforms.While,atthetime,noneofthesepotentialdisruptorswaspracticaloracompetitivethreattoourproduct,Icouldseeafuturewheretheywouldbe.Idecidedthatnightitwastimetosellthecompany.Despitethefactthatourbusinesswasgrowingrapidly,andwewereaddingcustomersbothnationallyandthroughacquisitionsatanincrediblerate,Isensedashiftwasgoingtotakeplaceinourindustry.Themarketwashotandtheexternalconditionswereright.Iwasontop,butitwastimetogetout.IreturnedtoHoustonandengagedtheservicesofaleadingMergerandAcquisitionsadvisorinourindustry.Afterreviewingourfinancials,diversemarquiscustomerbase,andgrowthrate,hewasalittleshockedthatIwouldbesellingthecompanywhenconditionsweresogood.WhileIdidn’ttellhimspecificallyaboutmyfearofthedisruptionIpredictedintheindustry,IdidtellhimIwantedtogetoutwhilewewereontop.Hesaiditwouldbenoproblemtosellthecompanyand,duetothemanyfactorsthatyouarereadingaboutinthisbook,wecouldsellitataveryhighpremium.Inotherwords,wecouldexitforapricewellaboveaverage.Itwasrightintermsoftimingandexternalconditionsand,asyouwillreadaboutinthenextchapter,ourinternalhousewasalsoinorder.IenteredintoanagreementtosellthecompanyinthelateFallof1999,andinJanuaryof2000,aftermakingsuretheworlddidnotimplodeduetoY2K,soldthebusinessforapricewellaboveaverageinavirtualallcashoffering.Wesoldthebusinesstoagroupofexecutivesfromoneoftheworld’slargestbusinessformscompaniesthatwasbackedbyprivateequitymoney.Iwalkedawaywithmyfamily’sfinancialfuturesecure,andtheypurchasedagrowingbusinesswithadiversecustomerbase,pristineaccountingrecords,greatemployees,andastellarreputation.Within5years,thecompanywentbankruptaselectronicsignaturepads,highspeedcopiers,andtheInternetreplacedbusinessforms—aproductthatwasnevergoingtogoaway.IoftenwonderhowI“sensed”theindustrywasgoingtochangewhentheirteamofindustryexecutives,investmentbankersandprivateequityfirmsstaffedwiththebestandbrightestMBA’sfromthetopschoolsinthecountrydidn’t.


23

Myguessisthattheindustryexecutivesknewnothingelseandburiedtheirheadinthesandatanytalkofchange,andtheinvestmentbankersweretootechnicalwiththeircomplexfinancialmodelsandgrowthratecalculations.Inhindsight,Isoldinaseller’smarketwithexternalconditionsalignedinmyfavor.Thenationalandlocaleconomywasstrong,theindustrywasgrowing,capitalwasreadilyavailable,andthesupplyofbusinessesonthemarketwaslowbecausebusinesswasgood,anditwasonlygoingtogetbetter.Therewasalotofconfidenceinthemarket.Thetidewasrising.Armedwiththisirrationalexuberance,thebuyersmissedthefactthatwewereapproachingthetopofthemarketandnewtechnologythatwoulddisrupttheindustrywasrightaroundthecorner.Businessvaluationispartartandpartscience.Theartisthemostcritical.IknowtheprivateequityfirmandtheirteamofMBAshaddetailedforecasts,projections,andcomplexspreadsheetscalculations.IfitwereafinanceprojectinanMBAclass,I’msuretheirteamwouldhavegotanA+.However,whatcountsintherealworldistheproperassessmentoffutureriskandgrowthopportunities.Mycalculationincludedalargediscountforthepotentialdisruptivechangethattechnologycouldbringaboutandtheirsdidnot.


24

Internal “Company Specif ic” Risk Factors

Whileanentrepreneurcannotalwayscontrolexternalfactors,internalrisksor“CompanySpecific”risksaretheonesundertheentrepreneur’scontrol.Thisisespeciallytruewhengivenadequatetimetodevelopaplantoeliminateormitigatesaidrisks.Theseriskfactorscontributethemosttoincreasingrelativevaluebetweensimilarbusinessesandarewhatformthebasisofaplantomaximizevalue.Inordertomaximizevalue,strategiesmustbedevelopedtomitigateinternalriskssuchas:

• Businessdependencyontheowner• Customerconcentration• Diversificationofcustomerbase• Contractedvs.non-contractedrevenue• Supplierrelationships• Threatsoftechnology• Legislativeimpacts• Incompletefinancialrecords• Onlinereputation• Patents

Valuationanalystsandinvestmentprofessionalshaveformulasthatattempttoincorporateandcapturetheseriskfactorsinaprocesscalleddiscountedcashflowanalysis.Theydiscountoverallcompanyvalueforeachriskfactoridentifiedandunmitigated.Entirefinanceclassesandvaluationcoursesarededicatedtotheseformulas,financialmodels,andcalculations.Thegoodnewsfortheentrepreneuristhattheunderlyingconceptandintuitivenessoftheseformulasareveryeasytounderstand.Financeprofessionalssimplyputariskfactoronimpactofthesepotentialriskstothebusinessanditscashflows.Attheendoftheprocess,thetotaloftheseriskfactorsisaddeduptogetaDiscountRatewhichistheexpectedoracceptablerateofreturnforthecapitalinvestedinthebusiness.TheDiscountRateissimplyanestimateoftheriskassociatedwiththebusiness.Thecriticalkeyfortheentrepreneurtounderstandisthattherewillbeadownwardadjustmentinvalueforeachriskthatisidentified.Theseriskadjustmentsresultinlowervaluationsandpurchaseoffers.Whilebusinessbuyersmaynotuseapreciseformulatodiscounttheserisks,theywillallrelatetotheRiskAversiontheorydiscussedearlier.Whenitcomestothepotentiallossoftheirmoney,theywillsubstantiallyloweranofferpriceforeachrealorperceivedriskfoundinthebusiness.Bythetimeanentrepreneurputsthebusinessonthemarketforsale,itisusuallytoolatetochangeanyoftheseriskfactors;theyaresimplyembeddedinthebusiness.Theentrepreneurmuststartworkingontheseriskfactorsseveralyearsinadvanceofsellingthebusiness.


25

Toanexperiencedpurchaserofbusinesses,riskislikea6thsense.Whenitpopsup,confidencedecreases,credibilityisreducedandalowerofferifanyismade.Attemptingtoputlipstickonthepigandcoveruptheserisksatalaterstageinthegamesimplydoesnotwork.Bythetimeapotentialbuyergoesthroughtheresearchrequiredtomakeanofferandcompletetheduediligenceprocess,eachpotentialinternalriskwillbeidentified,assessed,andanadjustmentwillbemadeinvalue.Theentrepreneurmustunderstandthateachoneoftheseriskswillimpactthevalueofthecompany.Whenanentrepreneurcannotmitigatetheserisks,thereisasubstantiallossofvalue.Companiesthatreceiveaboveaveragevaluationsarethosethatbestminimizeriskfactorsoutsideinvestorsfear. Hereisanexampleofhowthisworks:Outsideparties—especiallybankersanddebtproviders—wantcleanfinancialrecordsthattiehistoriccashflownumberstoverifiablesources.Thatsourcecanbetaxreturns,auditedorCPApreparedfinancials.Whentheserecordsareclean,professionallyprepared,andaccurate,outsidepartiesgainconfidenceandwillmakeahigheroffer.Whentheyareoutoforder,needtobeexplained,orcan’tbetiedtoaverifiablesource,theyloseconfidenceandtheyadjustpurchasepricedownwardfortheriskthatthecashflowrepresentedisnotaccurate.Thisissuchacriticalriskfactorthatitoftenbecomesthefirstnegotiatingpointtoalowerofferandvaluation.Toabankerorlender,thisriskcanimpactvaluesomuchthatitcanbecomeadealbreaker.Theywilloftenonlyusetaxreturnsorauditedfinancialrecordsastheamountofcashflowthebusinessgenerates.Imadeanofferonahusbandandwifeownedcompanythatembroideredshirtsandhats.WhenourCPAbeganduediligence,sheuncoveredasignificantamountofunreportedcashandpersonalexpensewriteoffsthatwereaddedbacktothetaxableincome.SheadvisedustonotgoanyfurtherandthatsheactuallyhadadutytoreportthisasillegalactivitytotheIRS.Wedidnotmakeanofferonthebusinessandanyoneelsemakinganofferwouldcertainlythinktwiceafterascertainingtheaddedriskanduncertaintyofpoorfinancialrecords.Whileitisunderstoodthatbusinessownerswilltakeeverydeductionpossibletominimizetaxes,theentrepreneurapproachingasalemustchangethisstrategyandensurethatfinancialrecordsarecleanandreflectnoaggressivetaxdeductions.


26

Whilea$10,000aggressivetaxdeductionexpensemaysave35%($3,500)intaxes,itcancostmanytimesthatinoverallvaluationandamuchgreaterlossincredibilityfor“cheating”ontaxes.ThisisjustoneexampleofmanyCompanyRiskfactorsthatimpactvalue.Theupcomingchaptersdiscussinternalfactors,theirimpacttobusinessvalue,andhowtheentrepreneurcandevelopstrategiestomitigatetheserisksandincreasethevalueoftheircompany.

Owner Dependency

Mostentrepreneurstakeprideinbeinghandson,meetingcustomersfacetoface,stayingontopofeverydetail,andworkinglonghours.Theyareextremelyproudandoftenthebusinessevenhastheirnameonthedoor.Theirpersistence,perseverance,andcommitmentarequiteoftenthekeystothesuccessofthebusiness.Unfortunately,ownerdependencyisoneofthebiggestandmostcommoncompanyrisksandvaluedestroyersofabusiness.Withouteverknowingit,theentrepreneurwhoisthemosthandsonisoftenthebiggestriskinthebusiness.Thedependencyontheowneristypicallythehighestpotentialdeductiononabusinessvaluation.Totrulycreatevalueinabusiness,anentrepreneurmustcrossthebridgefrom“workinginthebusiness”to“workingonthebusiness.”Whatthatmeansissteppingawayfromthedailyoperationsandlookingatthebusinessasanassetthatgeneratescashseparatefromtheentrepreneur.Businessesarevaluedbasedonthecashflowtheygenerate.Iftheownerorafewkeyemployeesaretheenginethatdrivesthebusiness,whathappenstothebusinesswhentheyareremoved?Inmanycases,thevalueofthebusinessissignificantlydiminished.Investorsandbusinessbuyersarenotlookingforajob;theywantabusinessthatgeneratesincome.If

theentrepreneurorkeymanagerscan’tbeawayfromthebusinessforanextendedperiodoftime,theenginecan’tberemoved,andvalueislost.Ofcoursenooneknowsmoreaboutthebusiness,theindustry,leadingandmotivatingemployeesthantheowner;however,whenitcomestobusinessvalue,noonecares.Ifthebusinesscan’tsurvivewithouttheowner,thenthebusinesshaslittlevalue.Thebestbookwrittenonthissubjectis“TheE-Myth”byMichaelGerber.Gerberrightlystates,“Ifyoucan’tseparateyourselffromthebusiness,thenyouhaveajobnotacompany.”Buyersandinvestorswillvalueabusinessthatisnotdependentontheownerorafewmanagersmuchhigherthanonethatis.


27

Ofcourse,tostartandgrowabusiness,theentrepreneurmayhavetohandleallthedaytodaytasks,fightthealligators,andbeajackofalltrades.However,whenthetimecomestocreatevalueandthinkaboutexiting,theentrepreneurhastobeinapositiontoworkonthebusinessnotinthebusiness.Whatdoesthismean?Hiretherightpeople,setupprograms,andestablishprocessesthatenableotherstorunthebusiness.Thebesttestforthisistoseehowlongyoucanbeawayfromthebusinesswithoutanimpacttosalesandprofits.Iftheentrepreneurcan’tbeawayfromthebusinessforamonthwithoutjustcheckinginoransweringafewquestions,thenthereisstillalotofworktodotobuildtherightteamandprocesses.

Highly Concentrated Customer Base

Customerconcentrationriskisaverycommonissueforeventhemostsuccessfulcompanies.Itisnotuncommonforaprivatelyheldcompanytohavehighlevelsofrevenuefromonlyafewcustomers.Manytimesahandfulofcustomersaccountforover50%ofallrevenuesandoftenthisnumberexceeds70%–80%.Overtime,manybusinessownersgetaccustomedtocustomerconcentrationanddon’tperceivethisasarisk.Aslong-term,stablerelationshipsdevelop,boththecompanyandthecustomercanbecomedependentuponeachother.Thiscreatesadangeroustrapandviciouscycle.Astherelationshipdevelops—and,inmostcases,sodoprofitabilityandrevenue—morecompanyresourcesareusedandaddedtoservethecustomer.Asrevenueandprofitsgrow,itbecomeseasiertoaddadditionalresourcestoservethesecriticalcustomers.Moreoftenthannot,thisisdoneatthesacrificeoftheonlystrategythatwillhelpsolvetheproblem—findingnewcustomers!Thesituationisakintoafrogboilingtodeathinwater.Whileabusinessownermaynotperceivethisrisk,itwillnotgounnoticedbyanypotentialinvestororbuyerofthebusiness.Overtime,managementmaybecomecomfortablewiththecustomerconcentration,buttherealriskofcustomerconcentrationishardtoignoreforanoutsideinvestor.Eventhebestcustomerswillbeexposedtoeconomicdownturns,changesinmanagement,newtechnology,changingmarketconditions,anacquisition,oranynumberoffactorsthatcouldforcethemtochangesuppliersorreduceordervolumes.Thisisariskthatmostoutsideinvestorswillnotaccept.Sowhatcanbedonetohelpmitigatetheriskofcustomerconcentration?

1. Continuetoputresourcesintodevelopingnewcustomersandmarketshare.


28

2. Builda“RainyDay”savingsaccountincasethedaycomeswhenyoureceivethephonecalloremailthatyourtopcustomerischangingsuppliers.

3. HavecustomersenterintoLongTermSupplyContractsorPreferredVendorAgreements.Thismakesswitchingmoredifficult.

4. Ensurethatallemployeeswhoservetheaccountareundernon-competeagreements.5. Haveaback-upplan:Whatwillyoudoifyouloseakeyaccount?Whatexpenseswillbe

eliminated?Whatstepswillyoutake?Entrepreneursmustrealizethatvaluationissignificantlydiscountedfortheriskofcustomerconcentration.Aplantodiversifyandspreadoutthisriskshouldbeimplementedtomaximizevalue.

Poor Online Presence

Withinthelastdecade,theinternethasbecomeaveryvitalandpowerfultoolinimpactingbusinessvalue.Thewebhasnotonlychangedthemannerinwhichbusinessesoperateandinteractwithcustomersbut,perhapsmoreimportantly,ithasalsochangedhowthebusinessandbrandsareperceived.AsWinnieHartofTwinEngineMarketing,averysuccessfulSocialMediaconsultingfirm,describes,“TheInternetgetstotheTruth.Acompanythatgoesaboveandbeyondtomeetcustomerneedswillberecognizedwithconsistentlystrongreviewsandratings.”Ontheotherhand,companiesthatfailtodeliverexcellenceintheirproductsandcustomerservicewillquicklydeveloppooronlinereviewsandreputations.The“Truth”eventuallycomesout.SiteslikeEBay,Yelp,VRBO.com(VacationRentalbyOwner),TripAdvisor,andAngie’sListworkbecausecustomersprovidehonestfeedbackandreviews.Readersofthesereviewscaneasilytellwhencompaniesgoaboveandbeyondorprovidepoorservice.Anoccasionalcomplaintcanbewashedawaywithoverwhelmingpositivefeedback,butcontinualbadreviewswillnotbeignoredandwillsignificantlyimpactvalue.

Manybusinessownersfailtorealizethatit’snotalwaysthesearchresultsthatarethemostimportant.Whatotherssayaboutthemandtheiremployees,andhowthebrandisperceivedonline,canmatterevenmore.WhileacompanythathasabusinesstobusinessmodelmaynotdependonagoodratingfromYelptobesuccessful,experienceasanexpertcanshinethroughinLinkedInarticlesandonlinediscussions.Youcanbetthatintoday’sworldanyoutsidevaluationofyour


29

companywillincludeaGooglesearchandathoroughreviewofyourFacebook,LinkedIn,andothersocialmediasites.Entrepreneursmustensurethattheircompanyname,brand,andexpertisecomeacrossstronglyandportraythemasanexpertintheindustry.Anybadcommentsfromupsetemployees,customers,orvendorscantarnishyourreputation.Youmustknowwhatsearchesrevealaboutyourcompanyandyourmanagementteam.Likeitornot,thefirstplacepotentialcustomers,employees,investorsandbuyerswillgotoresearchyourcompanyistheInternet.Withorwithoutyourapproval,thiswillbetheirfirstimpression.Althoughitcantaketime,perseverance,andcompanyresources,havingasuccessfulonlinepresencecanbeoneofthebiggestincreasersofcompanyvalue.Atthesametime,itcandestroyvalueasquickasthenextGooglesearchpullsupyourname.

Revenue Model

Businessesgeneraterevenueinavarietyofways.Whenteachingentrepreneursandstudentsaboutbusinessvaluation,thelightbulboftenturnsonwhenwebegintodiscussrevenuemodelsandtheirimpactonvalue.Theycaneasilyseethattwobusinesses,withthesameamountofrevenue,net


30

income,andinthesameindustryandgeographicalarea,canhaveawiderangeofvaluejustbasedonhowtheirrevenueisgenerated.Inthevaluationprocess,revenuemodelsarepriceddifferently.Recurringorcontractrevenuewillgetamuchhighervaluationthanprojectorbidtyperevenue.Entrepreneursshouldstrivetomakeasmuchrevenueaspossiblerecurring.Thiscanbeaccomplishedthroughcontracts,subscriptions,supplyagreements,annualpurchasecommitments,andanumberofotherwaystomakerevenuemoreconsistent.Forexample,$100,000ofnetincomefromacompanythathascustomersunderacontracttoprovideannualmaintenance,withaverylowpercentageofdropoffsfromyeartoyear,willgetasignificantlyhighervaluethanacompanythatprovidesnewconstructionandmustfindnewclientseveryyear.Project-basedbusinessrevenuemodelsaretypicallyatthelowerendofthespectrum.WhileIwasbuildingmyprintingcompany,andgoingthrougharapidgrowthperiod,IwenttoaHoustonAeroshockeygamewithRussellVail.RussellandIwerememberstheHoustonChapteroftheEntrepreneurs’Organization(EO).Russellhadrecentlysoldhisfirstcompany,analarmmonitoringbusiness.Thealarmmonitoringrevenuemodeltypicallyreceivesaveryhighvaluationbecauseithasbothcontractandrecurringrevenue.Icouldn’tbelievethevaluationandpurchasepriceRussellreceivedforthecompany.

Untilthispoint,Ihadbeensocaughtupinthedaytodayofrunning,managing,andgrowingmybusinessthatIhadneverreallythoughtaboutanendgame.TheconversationwithRussellreallyopenedmyeyestothepossibilitythatIcouldonedaysellmycompany.IaskedRussellabouttheprocessandwhatadvicehewouldgiveme.

AfterRusselldescribedthesale,hefollowedupwithaprofoundstatement;“Al,themostimportantthingyoucandoiscreatearecurring,predictablerevenuestreambyeliminatingtheriskassociatedwithit.”

Isaid,“Russell,Iownaprintingcompany,andweareproject-based.HowcanIdothat?”Hisreplychangedmylifeandfortunesforeverwhenhesaid,“Findaway.”

Thiswasaturningpointforthecompanyandmylife.Theresultofthatconversationwasthestartofastrategythatbecamethefocusformyremainingyearsintheprintingbusiness.Ibecameobsessedwithcreatingamorepredictable,lessriskyrevenuestream,soIcouldonedaymonetizeitsvaluelikeRusselldid.Eventhoughtheprintingindustryrevenuemodelwastraditionallyprojectandbidbased,Ilookedforwaystomakeourrevenuemoreconsistentandpredictable.

Wemovedfrombiddingonbigprojectstofindingmonthlynewsletters,contractstobethe“supplier”toafranchise,partnershipswithsoftwarecompanies(whentheyinstalledasystem,wegotthebusinessformsandprintingorders),contractstobeapreferredorapprovedvendor(webecamethe“preferredprintingvendor”forAnheuserBuschwholesalersandendedupwithover500ascustomers).

Whenweclosedoursaleandmywiretransferhit,oneofmyfirstcallswastoRusselltolethimknowhowhissimpleadviceandinspirationyearsearlierchangedmylife.Isoldthecompanyforavaluation


31

multiplemanytimeshigherthantheindustryaverage.Theinvestmentbankerwhoworkedonourdealandseveralothersforthecompanythatacquiredussaidhehadneverseenavaluationthathigh.

Lack of a Clear Vision and Direction

Agoodvisionclearlydescribeswhatthecompanyaspirestobeinthefuture.Agoodvisionhastheendresultinmindandprovidestheinspirationandreasonforfulfillingthecompany’smission.Asyouhavebeenlearning,valueultimatelycomesdowntothefuturepotentialofabusinessdiscountedfortherisk.Withoutaclearvisionanddirection,thereisanincreaseinuncertainty,andthiscreatesadditionalrisk.Entrepreneursneedtoknowandcommunicatewheretheircompanyisgoingandhowtheywillgetthere.Agoodstartistobeabletoanswerthesequestions:

1. Doesyourbusinesshaveavisionanddirectionthatcreatesacompellingimageofthefuture?2. Isyourvisionusedasaguidepostfordecisionmakingbythepeopleinyourorganization?3. Canyourvisionbeclearlycommunicatedbyyourmanagementteamandemployees?

Ifnot,thenit’stimetodevelopaclearvisionanddirectionforyourbusiness.It’sprettysimple;ifyoudon’tknowwhereyouaregoing,howwillyouinspireotherstohelpyouonthepathandgetthemexcited?Agoodvisionshould:

• Provideaguidelinefordecisionmakingthroughoutthebusiness• Buildalignmentandcommitmentatalllevelsoftheorganization

• Facilitatedesiredchange• Serveasaroadmapforfuturedecisions• Inspireandmotivateaction• Preparethebusinessforthefuture

Awellexecutedvisionbecomespartoftheorganization’scultureandcomestolifeintheeverydayactivitiesandactionsofyourmanagementteam.Investorsandbuyerswillquicklybeabletoascertainandevaluateifyourbusinesshasaclearandcompellingvisionanddirection.Whenthevisionandplanisclearandcompelling,therewillbeasignificantincreaseinvaluation.

Not Maintaining Good Financial and Corporate Records

Wecompletedthevaluationofabusinessthatownedseveralfranchiselocations.Unfortunately,theownerrantwoofthelocationsunderonesetofbooksandrecords.Theownernowwantstovalueandselloneofthefranchiselocations.Sincethereisnowaytovalidatetherevenuesandexpensesforthelocationonastandalonebasis,thismuddiedthewatersandresultedinasignificantlydecreasedvaluation.


32

Therearetwolessonshere.Thefirstinvolveslong-termstrategy.Ifthevisionandstrategywastodiversifyandbuildmultiplelocationsthatcouldbesoldindividually,thenthereshouldhavebeenseparatebooks,records,andtaxreturns.Thesecondisthatnotmaintaininggoodrecordswilldecreasevalue.Nothavingcleanfinancialrecordsmakesitdifficultwhenathirdpartylenderorinvestorneedssupportingdocumentssuchastaxreturnstoevaluatethecompanyanditsabilitytopaybackdebt.Inourpost-financialcrisisenvironment,lendersarerequiredtosupporteveryloanwithdetailedsupportingdocumentation.Nothavingcleanfinancialrecordsisammunitionforanacquirertodecreasethevalueofthebusinessandwillmakeitmorechallengingtogetthroughduediligence.Whenfinancialrecordsarenotclean,audited,orreviewedbyanoutsideCPA,duediligencecanbecomealongandexcruciatingprocess.Whentherearepoorlymaintainedfinancialrecords,itisnotuncommonforduediligencetolastmonthsortocompletelysabotageatransaction.Whenitcomestooutsideinvestorsandacquirers,everyaspectofyourbusinesswillbequestioned,scrutinized,andalltheskeletonswillcomeoutofthecloset.Runningatightship,documentingallprocesses,keepingallfinancialrecordsuptodate,closingthebooksonamonthlyorquarterlybasis,andhavingacompetentanddedicatedCPAwhocankeepyouadvisedofallaccounting,tax,legal,andHRregulationsarecritical.Accurateandup-to-daterecordsareaninvestmentthatwillbepaidbackmanytimesoverwhenitcomestoincreasingvalue.Theimpacttovalueandcredibilitycanbedevastatingifyourfinancialhouseisnotinorder.Gettingthroughtheduediligenceischallengingenoughevenwiththebestkeptrecords;itcanbecomeanightmarewithoutthem.Iamoftenaskedifauditedfinancialsorafinancialreviewisworththeinvestment.Financialstatement

developmentfallsintofourbasiclevels:

• InternallyCompiled—Preparedinternally• CPACompiled—PreparedbyoutsideCPA• Reviewed—ReviewedbyanoutsideCPAtoensuretheyarereasonable• Audited—Providesthehighestlevelofscrutinyandacceptance

Auditedfinancialsprovidetheultimatecredibilitytoinvestors,lenders,andbuyers.Theyarelikeaninsurancepolicyandassuretheevaluatorthattheyaccuratelyreflectthefinancialperformanceofthecompany.Ibelievethatauditedfinancialswillalmostalwayspayforthemselvesinthesaleofthe

businessandwillincreasethevalueofthebusinessinmanywayswellabovetheircost.Again,


33

increasingconfidenceisanoverarchingstrategyandobjectiveatalltimes.Providingauditedfinancialsisapowerfulstatementandwillincreaserespectandconfidence,aswellassetyouapartinthemarketplace.Ifitistoolatetohaveyourfinancialsaudited,thenafinancialstatementreviewofyourbooks,processes,andsystemsbyanoutsideCPAisrecommended.AfinancialstatementreviewensuresthatyourbooksandrecordsarepreparedtoGenerallyAcceptedAccountingPrincipals,“GAAP,”andarereasonablyaccurate.Ifthereviewissuccessful,thentheCPAwillstatethattheydidnotfindanythingmaterialorobvious.Areviewwillprovideahigherlevelofcomfortthaninternallypreparedfinancialssincetheywerereviewedbyanoutside,thirdparty.Afinancialstatementreviewcanalsocatchanypotentialissuesthatcouldcomeupduringnegotiationsorduediligencedowntheroad.

Key Employees without Non-Compete or Non Solicitation Agreements

Thepotentialofmanagersorkeyemployeesleavingtogowithacompetitor,starttheirownbusiness,ordivulgecompanyinformationisariskthatcansignificantlyimpactvalueandcannotbeignored.Thisisespeciallytrueiftheentrepreneurhasbeensuccessfulinremovinghimselffromtheday-to-dayoperationsofthebusinesslikeearliersuggested.

Theexistenceofnon-competeagreementshelpsaddressthisconcern.Awell-writtennon-competeagreementcanprotectabusinessandincreasevalue.Theseagreementshelptoprotectthebusinessfromtheriskofformeremployeesleavingtocompeteinsomeformagainstthecompany.Awellwrittennon-competemust

conformtostateandnationalemploymentregulationstobe

enforceable.

Inpracticallyallacquisitions,thebuyerandinvestorswillrequirethesellertosignanon-competeagreement.Youmustexpectandacceptthis,anditisusuallynotaproblem.However,manytimessellersaresurprisedtolearnthatthisrequestwilloftenincludepartners,managers,keyemployees,andevensuppliersandotherconsultantsattimes.Ifthisisnotapartofstandardoperatingproceduresforthecompany,itcanbeextremelychallengingtogetthemcompletedtomeettherequirementsofabuyer.Thesellerisgettingasubstantialamountofmoneytosellthebusiness;however,managers,employees,andevensupplierswhoareaskedtosignanon-competearenot.Theyaresigningawaytheirrightstoworkforacompetitororanothercompanyintheindustry.Signinganon-competeagreementcansignificantlylimittheiropportunitiestoworkinperhapstheonlyindustryorareatheyknow.Mosttimestheyarerightfullythinking,“WhathappensifIdon’tlikeworkingforthenewbuyerandwanttoleave?”Werepresentedthesellersofalogisticscompanythathadthreekeyemployees.Thebuyerandsellernegotiatedagreeableterms,andthebuyerrightfullywantedtoensureemployeeshadsolidnon-


34

competeagreements.Thebuyerdidnothavethemwiththeemployees.Thethreekeyemployeesrefusedtosignnon-competeswhenpresentedwithdocumentsbytheseller’sattorney.Thiscreatedablockingsituation,andthebuyerrefusedtogoforwardwiththetransaction.Notonlydidhebackout,buthesuedthesellerforhistimeandexpensesupuntilthispoint.Thesellerendeduppayingforthebuyer’sexpensestoavoidapotentiallawsuit.Beproactivebyestablishingstrongandenforceablenon-competeagreementswithallcriticalemployees,shareholders,andsuppliers.Entrepreneurscanunknowinglydestroyvaluewhenthereisanopendoorforemployeestogotoworkforacompetitor.Perhapsmoreimpactful,theycancreateasituationthatcanblockapotentialsaleifthebuyerinsistsonnon-competeagreementsandthekeyemployeeswillnotsignone.

Not Keeping up with Changes

EntrepreneurshipandbusinesshasalwaysbeenoneofthegreatestexamplesofDarwinism.Thosethatdonotadapttoachangingworldgoextinct.Thosethatleadthechangeandareearlyadoptersreaprewardsthattranslateintoadditionalbusinessvalue.Manybusinessbuyersseektoacquirecompaniesthathavenotadaptedorincorporatedadvancesintechnology,theInternet,orotherwaystoincreaseefficiency.Thestrategyistopurchasebusinessesatadiscountandusethemasa“platform”toincorporatechangesandupgradesthatquicklyincreasethevalueofthecompany.Theywillliterallycomeinwithascorecardthataddressesinefficienciesandareasthatcanbeimproved.Thewiderthegap,themore“discount”theygetinpurchaseprice,andthemoreopportunitytheyhavetomakeimprovementsandincreasecompanyvaluepostpurchase.Forexample,thevirtualofficeiscreatinganewparadigmthatisenablingbusinessestomovetoawholenewlevelofefficiency.Manyestablishedbusinessowners,includingmyself,fightitandinsistondowntownoffices,staff,andin-personmeetings.Itisthecomfortzone,thewaywealwayshaverunacompany.However,likemostdisruptivetechnologies,takingadvantageofopportunitiesthatcomewithremotestaffandgoingvirtualcanimprovethequalityofservice,drivedowncost,andcreatecompetitiveadvantagesthatalladdtoincreasedcompanyvalue.Businessleaderswhoarenottakingadvantageofthisareunknowinglydrivingdownthevalueoftheircompanies.Ascompetitiontakesadvantageoftheseopportunities,thosewhodonot,fallbehind.Letmegiveacoupleexamples.Wehadahusbandandwifeteamthatranaprofessionalservicesfirmasaclient.Theybothgraduatedfromtopgraduateschoolsintheirfield.Theyworkedforleading


35

companiesintheirindustryandlearnedthebusinessbut,insteadofclimbingthecorporateladder,theysteppedoutfrombehindthecurtainofabigcorporatenameandwentoutontheirown.Unlikestartupfirmsofthepast,intheirfield,theydidnothaveofficespaceandburdensofoverhead.Theytookadvantageofgoingvirtual.Theownersandemployeesworkfromhome.Theiremployeesareexperienced,credentialed,highlyrespected,andtheirclientshavenocluetheyallworkfromhome.Theydon’twastetimecommutingtoanofficeforendlessmeetings,andtheydon’tneedtobemanagedandbabysat.Theirfirmcanrampupresearchprojectswithsupportstafffromallovertheworldwhenneeded.Whenyouworkwiththeirfirm,youdon’tworkwithafreshlymintedassociatewhoisusingaprojectasaclassroomlikemany“bigname”firmsdo.Yourservicefeedoesn’tincludeadowntownoffice,staff,ora“blended”feethatincludesapartnerthatyouseldomseebutsupporttheirendlessperksandboondoggles.Yougetexperienced,provenprofessionalswithnofixedoverheadorimbeddedresourcecosts.Theyarenotalone.Isitonanadvisoryboardwiththeownerofacompanywhoemploysover300virtualcustomerandbackofficesupport.Theyworkforafractionofthecostandoverhead.Shecanrampupinbusytimesandscalebackwhenbusinessslows.IhavetoadmitIhaveovercomemyreluctance,andourfirmisnowtakingadvantageoftheopportunity.Ourmainfinancialanalystwhograduatedfromaleadinguniversityworksfromhomeandusessupporthelpandresearchersfromaroundtheworld.Weutilizeexperiencedandspecializedvaluationanalystsinourfieldwhenneededtoconsultandreviewvaluationreports.Theadvantagesoftechnologyandavirtualworldareallaround.Earlyadaptersaretappingintoworld-classtalentcreatingcompanies,utilizingsupportstaff,andeliminatingtraditionalfacilityoverheadtocreatelean,profitable,andmorevaluablebusinesses.Theyusetechnology,socialmediaadvertising,andmanyothernewinnovationstoincreasevalue.


36

Not Understanding Financial Rat ios and Relative Performance

Financialratiosandothercomparisonmetricstellalotaboutacompanyanditsperformance.Theyarealsocriticalkeytoolsindeterminingvalue.In2012,MiguelCabreraoftheDetroitTigerswonbaseball’sTripleCrownwhichwaslastwonin1967byCarlYastrzemski.CabreraledtheleagueinHomeRuns,RBI’s,andBattingAverage.Knowingjustthosestatistics,whatdoyouthinkthatsaysabouthisvalueasabaseballplayer?Ithinkyoucouldsafelydeducethathewouldbeextremelyvaluablewhencomparedtohispeers.FinancialRatiosarethestatisticsofbusinessandareusedbyvaluationanalystsandinvestorstohelpdeterminethevalueofabusiness.FinancialRatioshelpgaugeacompany’sperformanceinmanydifferentareasincludingfinancialsolvency,profitability,efficiency,returnoninvestment,andevenemployeeperformance.Valuationanalystsandinvestorscompareawiderangeofratiostoindustrynormsthatareavailablethroughvariousserviceproviders.Companiesthatareperformingbetterthanaveragetypicallygarnerhighervaluationsandmoreinterestbyinvestors.Inadditiontotheiruseinvaluationanalysis,businessownerscanusethemas“Dashboards”tomonitorcompanyperformance.Forexample,theQuickRatioisusedtoevaluatethepotentialofcashflowissues.TheQuickRatioisCurrentAssets–InventorydividedbyCurrentLiabilities.FormostcompaniesthisisAccountsReceivable+CashdividedbyCurrentLiabilities.Whiletheaveragevariesbyindustry,typicallyaratioof2:1andhigherisconsideredaboveaverage.Asthisnumbergetscloserto1:1andbelow,theprobabilityofcashflowissuesincreasesandthevalueofthebusinesswouldbelower.Whilethereareliterallydozensofratiosthatcanbeevaluated,ahandfulcangiveasolidinsighttotherelativeperformanceofacompanyespeciallywhencomparedtootherbusinessesinthesameindustry.Businessownersshouldworkwiththeirfinancialadvisorstounderstandfinancialratiosandhowtheycanbeusedtohelpmanagethebusinessandincreasevalue.WhilethereisnoTripleCrownforbusinesses,therearestillaboveandbelow-averageperformers.Takethetimetounderstandhowyourbusinessstacksup!Hereisalinktoawebsitethatlistsandexplainsmanycommonratios:http://www.investopedia.com/university/ratios/#axzz28AiTxvz3


37

Overly Aggressive Expense Deductions

Oneofthebiggestchallengeswithprivatelyheldcompaniesisalackofverifiablenetincome.Manybusinessesownersgetinthehabitofreducingtaxablenetincomeasmuchaspossible.Insomecases,deductionsblatantlycrossthelineastheydidwithonebusinesswevaluatedinwhichtheownerdeductedthefamilydogfor“security”andtripstoGreecetocheckoutpotentialvendors.Inmostcases,deductions,whilepushingtheline,donotcrossit.Thesetypicallyincludefamilymembersonpayroll,cliententertainment,personalbenefits,andtimingissueslikepushingrevenueintothenexttaxyearandacceleratingexpenses.Whilethesemaybebenefitstoownershipandcanreducetaxes,whenthetimecomestosellorvalueabusiness,overaggressivedeductionscansignificantlyimpactvaluationanddamagecredibility.Postthefinancialcrisis,lenders,investors,andvaluatorshaveanentirelynewstandardofduediligenceandincomeverificationrequirements.Non-verifiableincome,thatisnotonataxreturnorGAPpreparedfinancialstatement,istypicallynotcountedasnetincome.Let’slookatanexample:


38

Ifabusinessisvaluedat4x(times)netcashflowandthecompanyhas$250,000intaxableincome,thevaluationwouldbe$1,000,000.Ifthebusinessownerrunsmiscellaneousexpensesanddeductionsof$50,000tosaveontaxes,hewouldsaveabout$17,500ontaxesata35%taxrate.However,hecouldlose4x$50,000,or$200,000,invaluation.Inadditiontolosingpotentialvalue,businessownerswhopushthelimitsontaxdeductionsalsorisklosingcredibilitywithlenders,investors,andvaluators.Personaltripsandbenefits,familymembersonthepayroll,andotheraggressivedeductionsthatcrossthelinecanbeinterpretedasunethical,inadditiontoactuallybeingillegal.Whilepushingthelimitsmaybefinewhenrunningabusinessthatisyearsofffromapotentialsale,therearemanyriskstovaluationandcredibilitywhenitisclosetoapotentialsaleortransferofownership.


39

Impact of Taxes

Likeanythingelsetaxrelated,thebestadviceistoalwayshaveacompetenttaxCPAinyourcorner.Taxstrategiesaredependentuponthespecificsituationandparameters.Itisimportanttostartearlyandworkwithanadvisorfamiliarwithyourindustry,company,aswellasallstateandfederaltaxlaws.

Mostprivatelyheldbusinesssalesarestructuredasanassetsale.IfthebusinessisaC-Corporation,thentheassetsofthebusinessaresoldandfirsttaxedatthecorporatelevel.Thereisthenanadditionaltaxwhenthecashisdistributedouttoownersandshareholders.Thiscanresultinaneffectivetaxrateofnearly50%.Manybusinessownersareshockedtorealizethisand,unfortunately,thereisverylittlethatcanbedonetochangethissituationatornearthetimeofasale.Thefuturetaxclimatecanbestbecharacterizedasextremelyuncertain;thisisbroughtonbytheSupremeCourtupholdingtheAffordableCareActandanumberofprovisionsintaxcutsthat

aresettoexpire.Capitalgainsandestatetaxes,whichcansignificantlycutintotheproceedsfromthesaleofabusiness,areexpectedtoonlygoupinthefuture.Whencalculatingthevalueofabusiness,mostvaluationmodelsuse“FreeCash”floworaftertaxcashflow.Manybusinessownersdonotrealizethatthereisadeductionforestimatedtaxes.Taxstrategyandtimingplayanimportantpartindeterminingthevalueofabusinessandaninvestor’sreturns.Astaxratesincrease,thereislesscashflowtoinvestorsandowners.Significantchangesareforecastedinestatetax.Thistaxcouldincreasefrom35%thisyeartoapotentialmaximumof55%,andthelifetimeexemptionamountcouldgodownaswell.Thatmightmakeforsomeunhappykids.Theimportanceoftaxesinbusinessvaluationcannotbeunderestimatedandmustbetakenintoconsiderationbytheentrepreneur.


40

Assignabil ity of Contracts

Onesimplebutoftenoverlookedriskfactoristheassignabilityofcontractsfrombothsuppliersandcustomers.Thisoftencreatessurprisesandrearsitsheadinthemiddleofduediligence.Nothavingassignablecontractscanoftenbeamajordealbreakeror,attheleast,astumblingblock.We’veseenmanytransactionsslamonthebrakeswhilethesellerisforcedtoscrambletoensurethatsupplierorcustomercontractscanbeassigned.Valueisbasedonassumedfuturebusinessresultsandachievingthoseresultsmaydependonthecontinuationofacontract.Ifthereisariskthatanagreementcanbeterminatedwithachangeofcontrolornewowner,thenthatriskwillbetakenintoconsiderationwhenassessingvalue.Mostacquisitionagreementsrequirethatexistingcontractswillremainvalidafterachangeofownership.

Thelackofanassignabilityclausemayrestrictacompany’sabilitytoassignorconveyacontracttoanewowner.Itcanalsomakeacontractnullandvoidifasale,changeofcontrol,ormergertakesplacewithoutthechangebeingmade.Itisveryimportanttonotethatthisincludes:leases,loans,liens,licenses,alliances,supply/serviceagreements,realestatecontracts,employeeagreements,andamyriadofotherconditions.

Wewereinvolvedinatransactionbetweenanentrepreneurandalargepubliclytradedcompanyseveralyearsago.Therewasagreatfitbetweentwocompanieswithgoodsynergiesandcross-sellingopportunities.Theacquiringcompanymadeaverystrongofferthatwasacceptedbytheseller.However,whentheygotintoduediligence,thesellerfoundoutthecustomercontractswerenotassignable.Despitethefactthattheywerelong-termcontracts,therewasanoutiftherewasachangeofownership.Thiscreatedaverychallengingsituation.Thebuyerwouldnotmoveforwarduntilallthecustomerssignedoffonthechangeofownership,butthesellerdidnotwanttolethiscustomersknowhewascontemplatingthesaleofhisbusinesstothisspecificcompany.Thisresultedinanirreconcilabledifferenceandthebreak-upofthetransaction.Asanaddednote,marketconditionschangeddramaticallythenextyearaswemovedintothefinancialcrisisof2008-2009.Thevalueoftheseller’scompanydroppedtoafractionofthepre-crisisoffer,andhewasnotabletosellthebusiness.Toaddinsulttoinjury,thebuyerdecidedtoinvestandcreatetheirowndivision.Thisnotonlyremovedthemasapotentialacquirerbutalsocreatedanothercompetitorinanalreadysmallmarket.


41

Not Optimizing the Use of Capital

Manysmallbusinessownersoftenshyawayfromdebtorcreditlinesandactuallyendupwithhigherexpensesintheshorttermandalowerbusinessvalueinthelongrun.Whilethisseemscounterintuitive,companieswithgoodcashflowandgoodcreditcanusedebtandselectivefinancingtoimprovebothcashflowandbusinessoperations.Thechallengeforentrepreneursistonotabuseor“over-leverage”thisopportunitybytakingontoomuchdebt.Needlessdebtforextravagance,coveringuppoorcostcontrolsskills,shrinkingmargins,andahostofotherbadbusinesspracticescanmaskshort-termproblemsandevolveintosignificantlong-termissuesincludingbankruptcy.Thisiswhendebtgetstheentrepreneurintrouble.However,properdebtstrategiesandmanagement—suchasalineofcredit,short-termnotepayable,orotherformsthatthatcanbepaidbackoutofnormalcashflows—canbeusedtoincreasetheoverallvalueofthebusiness.Therecanalsobetaxadvantagesaswell.Whenthebenefitsoutweighthecosts,andtheexpensecanbebuiltintocashflows,interestexpensecanbelookedatasjustanotherexpenseofthebusinesslikesalary,rent,ortravel.Mostentrepreneurswouldn’tthinktwiceabouthiringanentrylevelemployeeat$2,000/monthbutwouldneverconsiderpayingthatinamonthlyinterestexpense.Usingdebtthatcanbeeasilyrepaidovertimeandoutofcashflowsforitemslikenewequipment,supplierdiscounts,higherqualityemployees,training,andotherimprovementsandefficienciescanbeusedtoincreasecashflowaswellasthevalueofthebusiness.Anotherbenefitoftakingonalittledebtisthatitgetsyourfootinthedoorandcanhelpestablisharelationshipwithalender.Althoughalargeloanmaynotnecessarilybeneededtoday,somewheredownthelinethebusinessmayrequirealoantofundanacquisition,capitalexpansion,orhireadditionalpersonnel.Makingpaymentsonsmallloanscanimproveyourbusiness’screditrating,increasecashflow,andbuildcredibilitywithlenders,soyoucanmovequicklyafteranopportunityifneeded. Anotheraddedbenefitissendingthemessagethatbothyouandthebusinesshavebeenabletoutilizefinancingandpaybackdebt.Thisdisplayoffiscalresponsibilitycanbeverypowerfultowould-beinvestorsandpotentialbuyers.Justremembertokeepdebttoequityratioslowandwellwithinthecapacityofthebusinesstopaythemback.Currently,interestratesareatnearhistoriclows,andithasneverbeenlesscostlytoborrowmoney.Obtainingaloanatacompetitiverateandusingittofundadditionalgrowthandincreasedefficiencycanincreaseprofitsandsignificantlyincreasethevalueofabusiness.


42

Not Protecting Intel lectual Property

ManybusinessespossesssomeformofIntellectualProperty(IP).ItiscategorizedintotwoareasbyTheWorldTradeOrganization:industrialpropertyandcopyright.Examplesincludeinventions,trademarksandtradenames,industrialdesign,literary,artistic,musicalworks,andmore.ThemostcommonwaystoprotectIParethroughpatents,copyrights,andregisteredtrademarks(andtradenames).SomeIP,however,isnoteasilyprotectableoranentrepreneurmaychoosetonotreleaseinformationtothepublicthroughthepatentprocess.Thisisoftenthecasewithtradesecrets(agoodexampleofthisisthecentury-oldrecipeforCoca-Cola).AsimplewaytogaugehowvitalcertainIPistoyourbusinessistoimagineascenariowherethatportionwasremovedorgreatlyinfringedupon.Askinghowthiswouldimpactsales,pricingstrategy,ormarketawarenesscanhelptogiveanideaofitsvaluetothebusiness.AvaluationprofessionalcanhelpcalculatethevalueofIPinasimilar,butmuchmoredetailedmanner.Whenitcomestotheoverallvaluationofabusiness,protectedIPcansignificantlyreducetheriskofcompetitionandreducedmarginsand,toaninvestor,thiscanbecritical.Mysister-in-lawistheinventorofaveryuniquewheelchaircover.Thecoverscanbecustomprinted


43

withdesignsandgraphics.ThecostsofthecoversareevenreimbursablebymostinsurancecompaniesandMedicarebecauseofthesafetyfeatureofprotectinghandsfromtheturningspokes.SheappliedforapatentbutwasturneddownbecauseofaverysimilarpatentinJapan.Eventhoughnoonewasactivelyusingthepatent,shecouldnotsecureanypatentprotectiononherdesign.SheauditionedforthepopularshowSharkTankandwasturneddownbecausetheproductwasnotpatented.Althoughshehasafantasticandpopularproduct,theriskof“copycat”productsandincreasedcompetitionimpactsthevaluesomuchthatshecan’tgetinvestors.Iheardagreatcommentinregardstothis;“Theearlybirdmaygettheworm,butthesecondmousetothetrapgetsthecheese.”Thisisparticularlytruewhenitcomestonewproductinnovationsandideas.WithoutIPprotections,manyfantasticfirst-to-marketproductscanbeeasilycopiedandmarketsthatwereopenedbytheinnovatorcanbeenteredbyothercompetitors.AdifficultquestionisdeterminingwhetherthecostofprotectingIPisworththeriskandwhatisthelikelihooditwillbeinfringedupon.Hiringpatentattorneysandotherprofessionalscanbeverycostlyandextremelytime-consumingforapatenttobegranted,ifatall.Thedecisiontoprotecttheriskisanimportantpartofthelong-termvaluecreationstrategy.ArecentclientintheOilfieldserviceindustryreceivedavaluationof1.5timestheirmostrecentrevenuesand9xearnings.Thevaluationwasoverdoubletheindustryaverageandover3timestheoverallaverageforabusinessthatsize.Indiscussionswiththebuyer,theyputavalueontheirpatentsof50%ofthetotalpurchaseprice.Theirpatentsaddedsignificantvaluetothebuyer.

Supplier Dependency

Anoftenoverlookedriskistheexcessiverelianceonamajorsupplierorevenemployee.Whilemaintainingagoodrelationshipwithamajorsupplierisvaluable,theassociatedriskofdependencycanimpactthevalueofabusiness.Thisisaverycommonoccurrenceandusuallydevelopsoveraperiodoftime.Suppliersareacriticalkeytomostbusiness’ssuccess.Inmanycases,oneortwosuppliersemergeasthe“go-to”sourceforproductsandservices.Asthesesupplierscomethroughwithrushdeliveries,betterterms,andastrongandtrustingrelationshipdevelops,theytendtogetthemajorityofbusiness.AsIbuiltmyprintingcompany,Idevelopedaverylong-standingrelationshipwithalocalpapersupplierandovertimebecameverydependentonthem.Ibecamegreatfriendswiththeownersand,inadditiontobusiness,wesupportedeachother’scauses.Theyalwaystookgoodcareofus.Theygaveme


44

favorablepricesandtermsandevenreferredseveraloftheirotherclientstousforacquisitions.Inturn,wegavethemthevastmajorityofourpaperbusiness.Whilethiswasagreatrelationship,itwasunknowinglyimpactingthevalueofourcompany.Whenanationalpapercompanyboughtthemout,webecamejustanothercustomeranddidnothavethe“intangiblerelationship.”Asaresult,prices,termsandevenpaperallocationduringtimesofshortagewerenolongerbasedontherelationship.Nothavingagoodrelationshipwithothersupplierslimitedourabilitytogotoothersources.Thereareanumberofstepsthatentrepreneurscantaketomitigatesingleormajorsupplierreliance.Theseincludehavingmultiplesuppliers,long-termcontracts,andback-upsources.Supplierrelationshipsandtheirpotentialrisksareanintegralpartofabusinessvaluationandbuyerduediligence.Thedependenceonsuppliers,andthecorrespondingrisktovaluation,willnotgetmissed.


45

Entrepreneurial Burnout

Oneofthebiggestandmosthiddenimpactstovalueisentrepreneurialburnout.Successfulentrepreneurshaveadrive,passion,andstrongemotionalconnectiontotheirbusiness.Theyareforwardlooking,goalorientated,andtheirgreateststrengthisworkingtowardsafuzzygoalinanuncertainenvironment.Intheearlyandgrowingstagesofthebusiness,thisisagreatfitandstrongelixirtothedriven,passionate,creativeentrepreneur.However,whenthebridgeiscrossed,andthechaoticstartupturnsintoanestablishedbusiness,thekeystosuccesschangetoadministration,processes,controls,andsystems.Thejoyofbuildingandgrowingthebusinessturnsintothedrudgeryofmanagingit,andthedrivenentrepreneurcanstarttoloseinterestaswellastheemotionaldrive.Thisistypicallynotafastprocess,butinsteadoccursslowlyovertime.ThejoyofworkingaquietSaturdaymorningoreveningwhenthephonesstopringingturnsintoaburdenandobligation.AlongweekendwithanextradayoffbecomespreferredovertheexcitementofgettingintotheofficeearlyMondaymorning.

CreatingandbuildingturnintoHRissues,IRSdeadlines,legalissues,andconstantadministration.Whatwasoncepassionateleadershipisnowtheresentedmanagementofissuesandproblems.ThelateHarvardMedicalSchoolandFounderoftheLevinsonInstituteforLeadership’sHarryLevinsonresearchedthisconceptextensively.Hisfindingsshowhowmanagementresentmentandburnoutimpactstheorganization,employeeperformance,andultimatelycompanyvalue.

Unfortunately,manyentrepreneursbegintheprocessofexitingtheirbusinesswellaftertheimpactsoftheirpersonalemotionalstateandbusinessvaluebegintodecline.Werecentlyworkedwiththeownerofaconsultingcompanywhosesaleshaddecreasedover20%inthelastyear.Heconfidedthathewasenjoyinghisdiscretionarytimeoutoftheofficemuchmorethanusingittoentertainclients,network,andbuildthebusiness.Helostthe“EyeoftheTiger,”andthereweremanymanifestationsofthisinhisbusinessincludingdecliningemployeemorale,increasedturnover,lossofkeycustomers,shareholderdisputes,andmanyothertangibleandintangibleimpacts.Entrepreneursmustbeextremelycognizantandself-awareofthisissueasitisoftenthe“SlowBurn”thathasthemostdevastatingconsequences.It’soktoacknowledgethatthejoyandrewardsofbuildingthecompanyarenotfoundinadministeringandmanagingacompany.Theearlierthisisrecognizedanddealtwith,thelesscompanyandemotionalvaluewillbedestroyed.


46

BelowarelinkstoarticleswithHarryLevinson’sviewsonthetopic.Takesometimetounderstandthisbeforeyoubegintodestroyvaluethattooksomuchtimeandenergytobuild.http://wweb.uta.edu/management/Dr.Quick/spring2012/When%20executives%20burn%20out.pdfhttp://www.leader.co.za/infocentrearticle.aspx?s=5&c=135&a=1407&p=2

Free Cash Flow

Abusinessisultimatelyvaluedbasedonthecashflowthatthebusinesswillgeneratetoitsowners.Alltheefforts,strategies,decisions,andyearsofworkcomedowntothis.Whilethebusinessownerhasalonghistory,emotionalconnection,andsensethatthisishisorherbaby,investorsandbusinessbuyersarepurchasingthebusinessforthecashflowthatwillbegenerated.TermssuchasEBIDTA,NetIncome,EBIT,aftertaxincome,freecashflowandmanyothersarecommonlyusedtodescribethisstreamofcashflow.ItiscriticaltorealizethatwhatmattersmosttothebusinessbuyerisFreeCashFlowor“FCF”.FreeCashFlowistheamountofmoneythatisavailableafterpayingallexpensesincludingdebt,interest,preferredshareholders,taxes,capitalimprovements,andanycashthatmustbeusedorleftinthebusinessforincreasesinworkingcapital.Attheendoftheday,FreeCashFlowisthemoneythatisavailablefortheownersandshareholderstodowhatevertheywantwithit.AsWarrenBuffetwouldsay,“Cashiscash,andallaccountingisuptointerpretation.”FCFcanbedistributed,reinvestedinunrequiredimprovements,setasideinretirementaccounts,orusedforadditionaldebtpayments.Itisthecashthatcanbeusedonceallobligationsandrequiredreinvestmentsinthebusinesshavebeenmade.Manytimessellers,businessbrokers,andevenCPAswilluseotherformsofincomeintheircalculationswhichcanresultinanover-valuingofthebusiness.ThefollowingformulaisusedtocalculateFreeCashFlow:Whilepastperformanceisoftenagoodindicatorofthefuture,itisimportanttonotethatthepastdoesnotalwaysequalthefuture.Youcannotsimplyextrapolatethefutureexpectedperformancefromthepastperformanceofthecompanyorvalueabusinessbasedonhistoricalnumbers.Youcanbesurethatanyonevaluingyourcompanywillbetakingintoconsiderationeconomicandindustryconditions,changesincompetitionandtechnology,capitalimprovements,regulations,aswellasanumberofotherfactors.

Net Income (after paying all expenses including taxes) + Non Cash Expenses (depreciation, amortization, deferred taxes and revenue) - Capital Expenditures - Additions to Working Capital - Debt Repayment - Dividend Payments to Preferred Shareholders = Net Cash Flow to Equity Owners


47

ThecalculationofFreeCashFlowandanyforecastingshouldbeleftuptoanexperiencedCPAandisoutsidethescopeofthebook.Fornow,justunderstandthatonceFreeCashFlowiscalculated,theexpectedreturnfortheriskfromallthefactorsthatimpactthebusinessanditscashflowwilldeterminethefinalvalueofthebusiness.Asdiscussedearlier,thebiggestmisconceptionthatbusinessownershavewhenitcomestobusinessvaluationisthatofsimplyapplyingsometypeofmultipletotheirearningswheninfactnothingcouldbefurtherfromthetruth!

Pull ing it Al l Together: Assessing Value

OnceFCFisestimated,ariskfactoror“DiscountRate”isappliedtotheestimatedfreecashflowthatwillcomefromthebusinessandthevalueofthebusinesscanbeestimated.Theconceptof“closeenough”for“HorseshoesandHandGrenades”isasmuchartasitisscienceandalsoappliestobusinessvaluation.WhenIstartedbuyingprintingcompaniesinmy20’s,Iwasabletointuitivelyunderstandandassessthevalueofabusinesswithoutanyformaltechnicalknowledgeorunderstandingofthevaluationprocess.ItmaynothavebeenderivedfromapplyingthetechnicalprocessthatIeventuallylearnedbutwithmycapitalandbankloansontheline,Icouldnotaffordtomissanyoftherisksembeddedinthebusinessoroverestimatethecashflowthebusinesscouldgenerate.Inhindsight,Idonotbelievethiswasanyspecialgift.Anyonestandingonahighdivewithorwithoutdivingexperienceassessestheriskofthedive.Asthedivegetshigher,theriskgoesupandtheconsequencesoffailureincreases.Riskissomethingthatweallunderstandatagutlevel.Withtimeandexposuretosimilarsituations,wecanbecomebetteratquantifyingandprocessingit.However,nodiver—eithernoviceorexperienced—wouldtakethechanceatahighdiveintouncertainwater.Humansareprogrammedtobothfeelandquantifyrisk.Whenexposedtoasituationsuchasbuyingorinvestinginabusiness,thissameinnateabilitykicksin.Whenitcomestoinvestingcapital,theconceptofriskaversionfurtherexaggeratesthisprincipalasdoestheabilitytowalkawayandeitherholdontoourmoneyorwaitforanotherdeal.Decreasingexcessriskanduncertaintyinabusinessiswhatincreasesvalue.Allbusinessbuyersandinvestorsarestandingonahighdiveassessingtheriskofdivingin.Theywillonlygohigherandinvestmoremoneyastheymoreclearlyunderstand,assess,andmitigatetherisk,uncertainty,andpotentialofthedownside.Ithinkmyexperiencebuyingprintingcompanies,growingthebusiness,andexitingtoaprivateequitycompanycapturestheessenceofthisconcept.Iboughtmyfirstcompany,StewartandSullivanPrinting,inmylate20s.Thecompanywasoneofoursuppliersandthetworemainingowners,HowardandGuyStewart,wereintheirlate60’slookingtosell


48

thebusiness.Fora28yearoldlookingathisfirstbusinessacquisition,itwasabigandintimidatingdecision.HowdoIhandletheproductionside?Whataboutthelegalissues?Istheirequipmentanygood?CouldIdependontheemployeestorunthebusiness?Wouldthecustomersleave?DespitethefactthatIhadknown,trusted,andworkedwiththemforyears,Iwasnowmakingadecisiontoinvestasubstantialamountofmycapitalandabankloanintothebusiness.Ihadtoassessthesituationandplaceavalueonthebusiness.Withoutanyknowledgeorexperience,Iwascompletingmyfirstbusinessvaluation.Themidtolate1980’swasapooreconomictimeinHouston.Theoilboomhadended,andtheenergyindustrywhichdroveHouston’seconomywasinaverydepressedstate.Justafewyearsearlierduringtheboomtimes,theeconomywasstrongandprintingcompaniesthrived.Theonlythingthatmatteredwasgettingthejobdoneandoutthedoorasquicklyaspossible,andStewartandSullivanhadbeenrunningaroundtheclock,sevendaysaweek,printingworkforthemajoroilcompanies.Despitethefactthatthelocaleconomyandindustrywasinadownstate,GuyandHowardtriedtoassuremethatitwouldsoonbebacktothewayitwasandwantedtobasethevalueofthebusinessonthisfact.Duringthestrongeconomy,afewyearsearlier,printingcompaniesbegantosproutupinlargenumbers.However,withthedownturnintheeconomy,competitionincreasedandprofitsweregettingsqueezed.Despitetheiroptimism,therewasnosignoftheindustryrecovering.Withoutanyknowledge,Ihadtakenthefirststepsinthevaluationprocessbyassessingtheexternalortimingissuesofthevaluationprocess.Thelocaleconomywasdepressed,interestrateswerehigh,andtheindustryhadalotofcompetition.Inaddition,therewerealargenumberofprintingcompaniesforsaleinthemarketplace.Inaformalvaluationprocess,theassessmentofexternalriskswouldhavebeenoneofthefirststepsintheprocess.

AsIquicklyfoundout,muchoftheirrevenuewasderivedfromafewkeycustomers,withverystrongpersonalrelationships,developedovertheyearswithtripstoLasVegas.Theybecamegoodfriendswiththeprintbuyersandreceivedthefirstshotatanybusinessthatcameout.Duringthegoodtimes,theyhitcapacitybyjusttakingcareofthesecustomers.Theyweretoobusyproducingordersandcountingthemoneyfromthesecustomerstogooutandmarketfornewcustomers.Thiscreatedanextremelyriskyandunpredictablerevenuemodel.

Asimpleanalysisofthefinancialstatementsrevealedthatthetwobrothershadbeenrunningalotofquestionabledeductionsthroughthebusiness—suchascars,lunches,tripstoLasVegas,familymembersonthepayroll.Virtuallyanypersonaldeductionthatcouldberunthroughthebusinesswasrunthroughwhichleftverylittlecashflowonthebooks.Nothavingcleanfinancialrecordstiedtothetaxreturnshurttheirvaluationandbecameamajorstumblingblocktocompletingatransactionandgettingbankfinancing.


49

Inadditiontohavingstrongpersonalrelationshipswiththekeycustomers,theyweredoingallofthemanagementandoperationalworkrequiredtorunthebusiness.Theywerequotingjobs,orderingmaterials,schedulingthework,andputtingoutallthefiresthatcameup.Thebusinesswasdependentuponthem.Allkindsofotherrisksstartedtopopup.Therewerenoemploymentcontracts,afewkeysuppliers,nodocumentedprocesses;theyhadoutdatedequipmentand,whenseparated,thetwobrothersaccusedeachotherofnotworkinghardenough.Theywerebothtiredandfedupwiththebusiness.Theyhadreachedthepointofentrepreneurialburnoutandwerereadytogetout.Withoutanyknowledgeofthevaluationprocess,Ihadestimatedtheircashflowandrevenuemodelandcompletedananalysisoftheexternalandinternalriskfactorsthatimpactedthecompany.Ihadwalkedthroughallthestepsandcompletedmyfirstbusinessvaluation.Fromthatcameanofferthatwassubstantiallybelowtheiraskingpricewithtermsthatwouldprotectmydownsiderisk.Theofferwasone-thirdcashupfront,one-thirdinanotetheywouldfinance,andone-thirdbasedontheperformanceofthecompany,paidoutovertime.Sincethebusinesswasdependentuponthem,oneofthemhadtostayonforaleastayear.Theydidn’tlikeourofferandtriedtoshopthebusiness.Intheend,theyacceptedmyvaluationandofferasthemarketconfirmedmyassessmentofthecompany.Althoughtheydidn’tlikeit,therewasnogettingaroundtherisksembeddedinthecompanyandtheexternal/timingconditionswerenotfavorable.Weeventuallycompletedadealbasedonmyterms.Inhindsight,GuyandHowardStewarthadunknowinglybuiltabusinesswithapoorrevenuemodelandexcessriskthatwasvaluedwellbelowitspotential.Buyingcompaniesliketheirsbecamealargepartofourstrategy.Iwouldlooktofindcompaniesthatwereundervaluedandmakeverylowoffers.Thetermsofone-thirddown,one-thirdinanote,andone-thirdbasedonperformanceneverchanged.Itwasmoreofatake-itorleave-itoffer.Overtheyears,Iacquiredaboutadozenorsocompaniesunderthismodel.

WhileIdidnotknowitatthetime,Iwasbuyingcompaniesthatwereunderaverageintermsofrelativevaluation.SinceIalreadyhadanestablishedinfrastructure,Icouldsimplyeliminatecostslikerent,accountingandotheroverheaditemsandconsolidatethemintomylocation.Thetermsofthedeal


50

provideddownsideprotectionandcreatedamechanismtolowerthepurchasepricefurtherifbusinesswaslostafterthesale.WhileIwasbuyingprintingcompaniesonthelowsideofaverage,therewereseveralbusinessbrokersthatbroughtmedealsthatwereattheoppositeendofthecurve.Thesebusinesseshadcleanfinancialrecords,diverseandwell-establishedcustomerbases,systemsandprocessesinplace,andotherfactorsthatincreasedtheirvalue.Iwasamazedatthepricesthesebrokerswerenotonlyaskingforbutgettingforthesebusinesses.ThebusinessesIwaspurchasingwerebelowaverageintermsofvaluation,butthebusinessestheyweresellingwereaboveaverage.Thedifferencewasallthefactorswehavebeendiscussing.Onarelativebasis,therewasmuchlessriskintheirbusinessesandrevenuemodels,andthesecompaniessoldforhigherpricesandbetterterms.IwouldliketosaythattherewasabigvisionandmasterplanbehindwhatIwasdoing.Inreality,Iwascluelessfromaformalstrategyandbusinessvaluationstandpoint.IwassimplystandingonthehighdiveandwouldnotjumpinunlessIwascomfortablewithavalueanddealstructurethatprotectedmydownside.AsIrelayedintheearlierstoryaboutrevenuemodel,alightbulbwentoffandmyentirelifechangedaftermyconversationwithRussellVailduringaHoustonAero’shockeygame.Likemostentrepreneurs,Ihadbeenhead-downinbuildingmycompanyandrunningthebusiness.EventhoughIhadbeenpurchasingcompaniesforquitesometime,Ihadneverreallythoughtofanexitformyself.Thiswasthefirsttimeiteverenteredmymind.AfterhearingRussell’sstoryaboutthelife-changingeventofsellinghisbusinessandadviceonbuildingamorepredictable,lessriskyrevenuemodel,Iunknowinglystartedputtingtogetheraplanandexitstrategyforthebusiness.Russell’sstoryhelpedsetmysightsonanendgameandgavemeaNorthStartosetmyfocuson.Webegantofocusonmorepredictablerevenuemodels,andmyentirelifeandbusinesschanged.Wemovedawayfromtraditionalbidworkthatwasinconsistentandunpredictableandstartedtogetagreementsandcontractstobethepreferredprintingvendorforfranchises,softwarecompanies,andothergroupsofaffiliatedcompanies.OurbiggestbreakcamewhenAnheuser-Buschgaveuspreferredvendorstatus.Oncethathappened,wehadaccesstoover1,000independentlyownedandoperateddistributorsaroundthecountry.Intime,over500ofthembecamecustomers.Thismodelwascopiedwithotherfranchisesandnationalcompaniesinavarietyofindustriesincludingdrycleaning,travelagencies,andotherbeveragedistributors.Itwasagreatcycle.Themorebusinesswegot,thebetterpricingandservicewecouldprovide.Businessboomed,profitsincreased,andIwasabletobelessinvolvedinthebusiness.Ifocusedmytimeandeffortonstrategiesthatincludedbetterpricingfromvendors,acquisitions,andfindingotherwaystocreateamorepredictableandlessriskyrevenuestream.Lifewasgreat.Thebusinessgrewthroughthe90’sandwasmakingnearly$1millionperyear.Then,acoupleofinterestingthingshappened.


51

Inalltheyearsofbusiness,weneverhadalawsuitorsignificantemployeeissues.Wewerelikeafamilyandhelpedouremployeeswithloanstobuyscars,year-endbonuses,holidayparties,andtimeoffwheneverneeded.Allofasudden,thingsbegantochange.Wehadtofireanemployeewhowaspregnant,oneofthesalesrepsfromanacquisitionhadabipolarconditionandthrewapairofscissorsataprintingpressoperatorwhentheinkcolorwasnotrightonajob,anemployeewithaseriesofDWI’sgotinanaccidentafteraholidayparty.Eachoneoftheseresultedinalawsuitincludinghavinganunsafeworkenvironment.Despitethefactthatbusinesswasgreat,andIcoulddelegatetheday-to-day,astheownerofthecompany,therewasnoescapingthesechallengesandtheiremotionaltoll.Ihadtoworkwithlawyers,settletheseissuesandtakethemtobedeverynight.Thefunwasstartingtogooutofthebusiness,andeventually,IsawasignalIcouldnotignore.AsIwalkedthroughtheNationalBeerWholesalersconventionin1998,IsawoneofourAnheuserBuschbusinessformswithacircleandaredlinethroughit.Iknewthisrepresentedthattheirsoftwarecouldreplaceourprintedproducts.Laterthatnight,Imadethedecisionitwastimetoexitthebusiness.Imadethreecriticalstrategicdecisionsinmycourseofstartingandgrowingmyprintingcompanythatprovedtobeextremelyfortuitousandwelltimed.ThefirstwastoacquireStewartandSullivanandstartdownthepathofacquiringprintingcompanies;thesecondwastodevelopthestrategyofcreatingapredictableandlessriskyrevenuemodel,whichunknowinglybecamemyexitstrategy,andthethird—whichchangedmylifeforever—wastosellthebusinesswhen Idid.

An Entrepreneur’s Guide to Understanding Business...

Documents

Transcript of An Entrepreneur’s Guide to Understanding Business...