Preparing for Profitable Sale - 10 Key Strategies
April 7, 2019
At some point in time, all small business owners should think about exiting their business. Options include:
· transfer it to an adult child
· sell it to employees
· sell part of the company to a 3rd party so you can take some of your capital “off the table”
· sell 100% to a qualified buyer
· plus others (ESOPs, using a charitable trust, donating to your church, etc.)
The first wave of baby boomers turned 65 in 2011, and many are already contemplating the sale of their businesses. If you are one of these boomers, or are just burnt out, desire to do something new or just thinking of selling, you can greatly increase the value of your business by first executing ten key strategies to prepare your business for sale.
Some actions can be implemented quickly, while others take years to execute properly. All will generate a strong ROI upon sale, and most will also improve your profitability and enjoyment of the business until that time. As a short cut, remember a simplified formula for business value: value = Profit1 divided by perceived risk. All the strategies below either increase profit and/or reduce perceived risk. They are listed below in approximate order of impact.
1. Improve the financial performance of the business.
If value in real estate is driven by “location, location, location” it’s driven in business by “financials, financials, and financials”. Profit and cash flow is the sina qua non for buying a business. Increasing Profit has a more than proportional impact on value; e.g., doubling your Profit will typically increase your business value 2.2 to 2.4 times. In general, buyers want to see at least $100,000 in annual profit (and sometime more in Hawaii because of our high cost of living), and interest in your company will increase exponentially with Profit above that level. Buyers value, in addition to bottom line Profit, strong revenue growth and high gross and net margins.
2. Clean up your books and records, especially your tax returns.
An old business sales adage reads “you are paid on what you can prove, not on what you earn.” Proof in the world of small business sales primarily means your business tax returns. Anyone can claim they are making an enormous profit. Buyers will believe the profit is real when you pay taxes on it, at the corporate level and/or on your owner W2 compensation. Buyers understand that business owners want to minimize their tax obligations and expect to see some “discretionary expenses2” paid for by the business. But to get maximum value, those expenses must be a moderate percentage of the true total profit, well documented with receipts, clearly discretionary in nature and appropriate categorized on your tax returns. Buyers will also want to see GE tax returns consistent with the federal returns, and bank statements verifying the advertised cash flow. You will get no credit for “off the books” cash sales. Hire a good CPA to review and clean up your financials, establish solid accounting systems and controls and to prepare your taxes.
3. If your business is location dependent, lock up a favorable long term lease.
For location dependent retail and restaurant businesses, the lease is the critical risk factor that can make or break your business and the value realized upon sale. In general, the longer the lease (and options to extend), the better. When renegotiating your lease, make sure the lease is assignable without excessive restrictions or financial penalties or payments. Some landlords are slipping provisions into their leases that give them 50% of your sale proceeds as payment for assigning the lease. Avoid letting your rent rise at a faster rate than your sales are likely to increase, or the margin erosion can severely erode profits and make the business impossible to sell. No matter how good your relationship with the landlord, never just assume s/he will extend your lease or let you assign it to a buyer. Get it in writing. One caveat on signing a long lease before sale: the landlord will almost certainly hold you secondarily liable, via your personal guarantee, if the buyer defaults on the lease.
4. Diversify your customer base.
For non location dependent businesses, high customer concentration is often the biggest risk factor. If one or just a few customers account for a significant portion of your revenue, buyers will be make lower offers and/or with deferred payments contingent upon customer retention after the sale. Even if you are 100% confident those customers are loyal to you, a prospective buyer will not assume, nor pay for, this presumed loyalty. The obvious solution is to add new customers to diversify your revenue base. Less effective is putting customers under written contracts with a provision allowing you to assign the agreement to a qualified buyer.
5. Diversify your product/ service base and create recurring revenue.
If the majority of your revenue comes from one or a few products or services, you can reduce your risk by diversifying revenue across other products and services, unless it is certain there will always be a demand for your product or service. When adding new offerings, keep in mind that buyers love companies with regular recurring revenue streams. Businesses such as security alarm companies and property management firms, which get paid monthly from hundreds of customers, sell for exceptional premiums. Look for opportunities to add products and services with recurring payment features, such as long term maintenance agreements, retainers for professional services, or automatically charged renewals or annual upgrades.
6. Strengthen your management/ employee team.
Any business owner knows how hard it is to get good people, and how frustrating it is to deal with unreliable or poor performing employees. So it follows naturally that the number and quality of managers and employees in a business increases its desirability. Diversification can be important here too. If your company will be severely damaged by the departure of any one employee, it’s critical to recruit and/or train other employees to lessen the risk. Recruit part time employees to cover less desirable shifts and to fill in for sick or vacationing employees. Replace family members in the business with non family employees if possible. Get rid of problem employees and address any current or potential labor disputes.
7. Strengthen operational, marketing and administrative “systems”.
Franchised businesses consistently sell for a significant premium to independent businesses. Most of the premium is due to nationwide brand name recognition, which is nearly impossible for a local only business to replicate. But part of this premium comes from the strong support and well documented operational, marketing and administrative systems franchisors provide their franchisees. By creating similar systems, you will greatly increase prospective buyers’ confidence that they will enjoy the same success as you, and thereby increase what they are willing to pay. Read the bestselling e-Myth books for details on creating systems. Investments here will improve profitability and help your business run more smoothly.
8. Secure key suppliers obtain exclusive rights and/or build barriers to entry.
Buyers love businesses with exclusive rights to sell any product or services, even if the exclusive territory is limited. Exclusivity almost inevitably leads to higher and more secure margins and profits. If exclusive arrangements are not possible, try to negotiate long term assignable supply contracts. Look for ways to create barriers to entry for competitors, such as through exclusive partnerships or through (legal) tying arrangements. Invest in equipment, technology, patents, copyrights and the like that exclude competitors or differentiate your company.
9. Maintain and upgrade equipment and facilities.
There is a natural tendency among owners contemplating a sale to cut back on capital investments and even equipment maintenance. But inevitably this lack of investment will become apparent to buyers who will deduct value accordingly, especially if it leads to falling customer satisfaction or competitive position. That said, it is generally not a good idea to make larger than normal capital investments in the 1-3 years preceding a sale, as the investments will be difficult to recoup.
10. Make the business less dependent on you.
If your business cannot run without you, it has little value to someone else. If you diversify your customer base, build your management team, create outstanding systems, etc.—in short, execute all the strategies above—your business will naturally become much less dependent on you. You will be able to work fewer hours, take long vacations and still make good money. You will have made your business supremely saleable and, ironically, one you may no longer want to sell.
We hope this information is of use in building your business. Call us anytime for a free, confidential estimate of the value of your business.
It goes without saying that sellers should retain a professional business broker like Hawaii Business Sales to represent them during this process.
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Definitions
1. By “Profit”, technically we mean Seller’s Discretionary Earnings, a measure of the total annual financial benefit accruing to the owner of a business. This is defined roughly as: pretax net income, plus owner salary/ compensation, plus interest expense, plus non-cash expenses (depreciation and amortization), plus……
2. “Discretionary Expenses” paid by the business, that benefit the owner personally, with minimal benefit to the business (such as owner’s medical insurance, personal auto expenses, optional travel, etc.).