An Entrepreneur’s Guide to Understanding Business...
Transcript of An Entrepreneur’s Guide to Understanding Business...
An Entrepreneur’s Guide to Unlocking Business Value Al Danto
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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
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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
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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
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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.
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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.
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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.
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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.
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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.
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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?
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• 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
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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.
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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.
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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.
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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.
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Thesesamecompanies,thatonlyyearsbeforewererunningshiftsaroundtheclockandchargingpremiumprices,werehappytotakevirtuallyanyofferthatwouldgetthemoutofthebusinessandtheirchokingoverheadthatwasbuiltupduringtheprecedingboom.WhileIdidn’tunderstandthefirstthingaboutformalbusinessvaluationortheimpactofeconomicconditionsonbusinessvaluation,IfiguredoutprettyquicklythatIcouldpickupbargainsduringthesetougheconomictimes.Houstonbusinessownerswhosoldduringthegoodtimesafewyearsearlierreceivedsubstantiallyhighervaluationsthenthosewhowaited.
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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.
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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
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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.
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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
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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.
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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,
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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
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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
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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.
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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,
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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-
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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
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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.
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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
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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:
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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.
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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.
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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.
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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.
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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
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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
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favorablepricesandtermsandevenreferredseveraloftheirotherclientstousforacquisitions.Inturn,wegavethemthevastmajorityofourpaperbusiness.Whilethiswasagreatrelationship,itwasunknowinglyimpactingthevalueofourcompany.Whenanationalpapercompanyboughtthemout,webecamejustanothercustomeranddidnothavethe“intangiblerelationship.”Asaresult,prices,termsandevenpaperallocationduringtimesofshortagewerenolongerbasedontherelationship.Nothavingagoodrelationshipwithothersupplierslimitedourabilitytogotoothersources.Thereareanumberofstepsthatentrepreneurscantaketomitigatesingleormajorsupplierreliance.Theseincludehavingmultiplesuppliers,long-termcontracts,andback-upsources.Supplierrelationshipsandtheirpotentialrisksareanintegralpartofabusinessvaluationandbuyerduediligence.Thedependenceonsuppliers,andthecorrespondingrisktovaluation,willnotgetmissed.
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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.
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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
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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
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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.
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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
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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.
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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.