Questions & Answers - January 17, 2020
There are 3 approaches to valuing a business; the asset approach, the income approach, and the market approach.
The Asset Approach focuses on the components of the company - the tangible and intangible assets. You value them individually then add them together to come up with a value. It typically renders the lowest value but I tend to only use it when I have another performing company and there’s not a whole lot of goodwill associated with the company.
The Income Approach is based on forecasting. In the space that I work in, the small business forecast is extremely difficult. The only time I ever use them is if my client has a history of being able to forecast accurately their next two to three years and yet that’s not enough. So if you are unable to forecast with any degree of certainty, it’s probably not the approach for you.
The Market Approach, which I spend most of my time using, is based on privately held sale data and apply to the company we’re valuing. We’re looking at revenue and cash flow and we apply it to the company we’re valuing. That serves as a proxy for value. As much as I don’t like the analogy, think of the market approach as valuing a home. You see other homes with 4 bedrooms, 2 baths, within a certain area, and you can apply what you learned about those homes and apply to your home to get a rough estimate. Same thing you can do with a business. The challenge that we have is market data, but if you listen to my podcast with Kenny Woo and Adam Munson from DealStats, you will hear how we get that information and how we apply it.
Just as indicated on the podcast, most businesses are saleable at some price. The challenge becomes a matter of risk and reward and identification of value. In the case of customer concentration, we bump into “How does the buyer mitigate that risk?” because post-sale they don’t know what’s going to happen whether or not that buyer/customer is going to stay with them. “What’s the relationship with you and the owner?” “How does that work?” If I’m a buyer I have to come up with a way to mitigate that risk and typically it’s done through Gift and Fit Financing. If X, Y, and Z happen, I will pay you X. So, that’s the challenge with customer concentration.
Now, let’s address the 40%. As you examine the 40%, I think the first couple of things you need to examine is where is your profit coming from. For example, we had a client who lost 20% of their business but it was making up 40% of their profitability, so it was a considerably bigger hit. My suggestion would be to dig deep into that customer and see how valuable they are to your business.
Addressing the saleability matter, yes, I think it is. But I think you need to understand that so long as there’s a customer concentration challenge that the buyer is going to have to mitigate that risk. That’s going to spook the lenders and it’s going to spook the buyers. So, what do you do? The first thing you can do is anticipate that the buyer is going to make part of the price contingent upon the retention of that customer. You may have to alter some of your post-sale plans in order to accommodate that transition. Second, you may have to stay with the business in elongated time to ensure that that client/customer is transitioned over to the new buyer. You may want to deploy some sort of incentive program for those within the organization or salespeople that can help you diversify that customer base.
I am not going to sugarcoat that it is a challenge, one of which is surmountable. But you’re going to have to understand that it’s going to take a little bit more than the normal deal in order to get out from under it. If you are looking for some ways to diversify your customer base, email me offline at email@example.com and I will do what I can to help you out.
Unfortunately, this is one of those things where I have to say “It depends”. Some buyers prefer independent businesses where the others are just the opposite. They need a system that has been worked out that they can simply follow, and if they do everything they’re supposed to do they should be able to turn a profit.
Let’s take a look at some of the attributes related to independent as well as franchise businesses. The ownership model is the first thing. And when we look at it, franchises are a system. There’s an infrastructure put together and everything is systematized. Whereas the independent system may not be systematized, and so it requires the owner to put in more effort in order to operate the business effectively. If you have ever read Michael Gerber’s The E-Myth Revisited, you will see that it’s one of the things; systematizing the business so it’s almost operating like a franchise.
Next thing you have to consider the size. If you are an independent business, you may have a corner on a particular type of service or product that you’re selling. But if you look at a franchise, for example, chances are they’re probably a national brand and they have better name reputation that you. If you have a local presence, then they probably have a national presence. Probably the last thing that I would bring up is the success rate. I mean, the proof is in the pudding.
When we look at both types of business, I think you find that it’s debatable whether or not one type of business is better than the other. You have to evaluate each business based on its merits. I was speaking at an event the other day and they brought up the topic of Subway. If you took a Subway sandwich shop that was generating $200,000 profit and you have Joe’s sandwich shop that’s also generating $200,000 in profit, which is more valuable? Likely, it’s the Subway because the Subway has less risk associated with it and that it will be reflected in the multiple.
Questions & Answers - January 10, 2020
As a general rule, here are the factors that have to be in place for you to likely to be able to sell your company:
- Profit. A buyer has to be able to pay the debts to acquire the business and get a return of the owner of the investment. There has to be that profit available in order to do that.
- Location. If you have dismal location chances are that the buyer is probably going to take a hard pass. For example, in manufacturing, access to rail or highways or air is important. Having an ideal location amplifies the likelihood of a sale.
- Equipment. The equipment has to be in good operating condition.
- Inventory. If the business is selling products, the inventory that the buyer is acquiring has to be a good saleable inventory.
- Customers. Customer concentration, the composition of customers, longevity of customers... these make the business saleable. If you have long-term contracts, that’s a good thing for a buyer because it makes the future revenue predictable. And predictability in small business amplifies value, not detracts it.
- Competition. Look at what the competition is out in the marketplace. Is it a saturated market? Is it a race-to-the-bottom-with-the-lowest-price-wins? Is there an opportunity to take advantage of the unique attributes of your particular business in order to compete at a much higher level?
- Intangible Assets. If you have copyrights, or trade secrets, or intellectual property, that is something that amplifies the value and increases saleability (assuming that it can be transferred to the next person).
- Accounts Receivable. This goes hand-in-hand with customers. If you have a composition of sloping customers, that is a red flag because the quicker cash comes in the less working capital that the buyer has to obtain in order to acquire the company.
- Employees. Having a good quality workforce is certainly a big plus. In fact, there’s a lot of companies that acquire other companies just simply because of the opportunity to acquire talents.
- Their own database. Ed and his team have done roughly 2,100 deals so they have a lot of empirical evidence within their four walls.
- When Ed goes outside, he goes to a few places to find market data:
Look at it from the standpoint of “Are you a target?”. If you look at the landscape of who are your potential buyers, look at customers, suppliers, competitors, who would benefit from acquiring you? From a cost standpoint, do you share the same suppliers, vendors, customers? All those types of attributes amplify value.
The rule of thumb is that the target company is five times smaller than the acquiring company. If you're doing a $1M in revenue, a $5M company is the likely candidate to acquire. There are differing opinions on why that is, most of it has to do with risk. When we look at putting the two companies together in order to mitigate the risk, the company tends to be substantially larger than the company that’s for sale.
Ed wants to stress caution in approaching a competitor. It’s better to approach an intermediary just simply because you can maintain confidentiality on a more sound basis than you personally doing it.