Critical Value Factors When Selling a Business

Part 3 of 3 in the Big Sky Business Journal

In a past column, we reviewed some high level considerations for a business owner who is thinking about a future ownership transfer. The article followed a conversation with Jim, who is a business owner wanting to make sure he has a valuable and sellable business when he decides to retire. In this article, we will look at some of the top factors that make a business valuable and sellable.

Value drivers are the business attributes that give a business real and perceived value. A buyer's questions will be centered on the value drivers in the business.

Cash flow is king. Buyers need cash flow in order to make a living, generate a return on investment and pay back a loan. What aspects of cash flow are important? The most valuable cash flow is, (1) reported, (2) consistent, (3) growing and (4) expected to continue in the future.

Reported cash flow is important because business valuation relies heavily on the profit history in order to help project future cash flow. Some businesses minimize reported profits. When I see financial statements that do not reflect the actual performance of the business, I visualize dollar bills flying away in the wind. I regularly see personal expenses such as family vacations (competitive research expense or travel), personal trips to Costco (office supply expense), a son's racecar sponsorship (marketing expense), or the wages paid to a child who is away at college. I acknowledge the savings from tax deductions, but the value of higher profits in a sale will far outweigh any loss of tax deductions.

Steady cash flow gives a buyer higher confidence in future returns. Profits that vary, let's say, 30% from year to year will require a buyer to form a contingency plan for lower profits. Consistent monthly cash flow is preferable to seasonal cash flow.

Profit growth is usually more significant in a buyer's eyes than a business owner's eyes, because a buyer has higher sensitivity to risk. Nobody wants to 'catch a falling knife', a term used to describe a sharply declining business.

The first three characteristics of cash flow—reported, steady and growing—along with other internal and external factors give the expectation of cash flow continuing in the future.

Human factors influence every company's value and they are more complex than many other value drivers. Companies are valuable partially because they have a trained workforce and a qualified management team. Owners are well advised to invest in people and in company culture, which drives the health, performance and turnover of a workforce.

The culture will shift during an ownership transfer, so employee loyalty needs to run deeper than the owner's personality. Employees are only valuable to a buyer if they stay through the ownership transition and continue performing into the future. Buyers don't care about the great employee that just left.

So how does a business keep its people? One tool that supports an exit strategy and fits into the existing organizational structure is an incentive and retention plan that rewards key employees for measurable performance and defers the payout of the incentives over time. This structure motives top performance and the deferred payout helps retain your people. Turnover cost is massive in any business and it costs even more in the middle of an ownership transition. The loss of a key person at the wrong time may even threaten a deal with a buyer.

Independent surveys and employee assessments can help you keep track of the health of your workforce and stop turnover before it happens.

Now customers will take the stage. Everybody knows customers are important, but what exactly makes them valuable to a buyer?

Customers are valuable because we expect them to buy again in the future. Three key factors point to the value of a customer base. First, how satisfied are the customers. Second, how "sticky" are the customers? Third, what is the loss if a customer leaves?

Every business thinks they have highly satisfied customers, but we are often our own best fans. Independent and objective measures of customer satisfaction will reveal areas we can improve. Third-party customer surveys are crucial for making ongoing business decisions and for proving the value of customers in a sale.

A "sticky" customer is one that comes back. There are soft reasons why customers come back such as customer service and relationships, but often relationships change in an ownership transfer. The only customers valuable to a buyer are the ones that are going to stay. We like to think of customer "stickiness" in terms of four tiers of recurring revenue.

(1) A One-time Customer is the least valuable customer because we do not expect them to come back. A good example is the owner of a custom home, who is unlikely to hire the builder again.

(2) A Repeat Customer is one that orders periodically. For example, a business might place an order with their print shop every 2-3 months. This customer is somewhat valuable, but there may be little holding them to the company.

(3) A Recurring Customer is on a regular billing cycle and has inertia that keeps them coming back. An example would be a janitorial company that has ongoing commercial accounts.

(4) A Subscription or Contracted Customer is the most sticky and valuable form of customer. Typically it would be difficult and costly for them to switch to a different provider. An example would be a software subscription or a service contract. Make sure any contracts are assignable.

Recurring customers bring cash flow stability. Most businesses can develop a business model with recurring revenue for at least a portion of their sales. This could be as simple as introducing customer contracts in a service business. Product-based businesses may want to focus on selling a consumable item related to the product.

In cases where a product or service is one-time nature, such as a company providing fire and water restoration services, there is still hope of significant value. Consistent future cash flow can still be achieved if the company has a proven sales system that generates consistent new customers without owner dependence.

The third variable in the value of customers is concentration of revenue. How will the loss of any one customer impact the business? I know a growing manufacturing company that has one customer buying 70% of their production. They are operating with significant risk because there is no contract or other commitment in place.

To find customer concentration percentage, simply divide the sales from the largest customer by the total sales. Customer concentration over 10% represents a noticeable risk and concentration over 25% will materially reduce the business value. It is helpful to repeat the calculation with the top three customers and to consider how top customers impact profit margins.

Companies that have high customer concentration at the time of an ownership transfer will likely see a portion of the sale price being contingent on retaining certain customers.

If you were buying a business would you want growth potential? Scalable businesses have a business model that can support growth without an increase in fixed costs or investment. For example, when a business would need to invest in equipment or facilities in order to grow, then the overall required investment is higher. If the business can grow with little capital investment, then the buyer can pay more to the owners and the business is more valuable.

Another factor that makes a business salable is having trained employees who follow "best practices" and standard procedures. An owner who micromanages the delivery of the service or product has placed a short leash on company growth. That situation also raises the risk during an ownership transition. Your vitamin manufacturer, your airline, and your doctor all use checklists and standard procedures to assure consistency. Why not your business?

Buyers discount the value if they find deferred equipment maintenance, equipment at the end of useful life, unsalable inventory, uncollectible receivables, non-assignable contracts or leases, uncooperative partners or employee problems.

As you prepare an exit plan, recruit your advisors to review your company from a buyer's perspective by going through the same 'due diligence' process a buyer will use. There is no substitute for an independent viewpoint on your business. Due diligence is like getting an x-ray of your business. There is no place to hide, so you need to know the anomalies, and fix them, before a buyer finds them in due diligence.