1. Corporate Governance Risk
The risk that insiders (employees) won’t act in the best interests of owners (stockholders) and the community.
2. Competitive Risk
The general risk that you’ll lose out to the competition.
3. Innovation Risk
The risk that the competition will out innovate you.
4. Intellectual Property Risk
Risk related to intellectual property (e.g. the risk that intellectual property leaks to competitors).
5. Merger & Acquisition Risk
The risks related to integrating firms.
6. Business Risk
The risk that your overall business strategy and plan will be
ineffective (e.g. will fail to meet revenue targets).
7. Economic Risk
The risk that the economy will go into recession. In some
cases, recessions benefit a business (inferior goods).
8. Technological Change
The risk that technology investments will become obsolete.
9. Change Management Risk
The risks associated with managing change.
10. Project Risk
The risk that projects will fail.
11. Ethics Risk
The risk that your guiding principles and ethics will be breached.
12. Reputational Risk
The risk of damage to your corporate image. Reputational risk can reduce trust in your business and lead to destruction of value.
14. Profit Risk
The general risk that profits will fall.
15. Capital Availability
The risk that you won’t be able to fund your business.
16. Asset Risk
Risks related to asset prices (e.g. real estate).
17. Interest Rate Risk
The risk that interest rates will change.
18. Currency Risk
The risk of a change in exchange rates against your favor. For example, if your costs are in US dollars but your revenue is mostly in Japanese yen — you want a strong yen.
19. Inflation Risk
The risk of price increases in critical inputs (e.g. energy for the transportation industry).
20. Investment Risk
The risk of a change in value of investments (e. g. Equity & Commodity Market Risk).
21. Liquidity Risk
The risk that you won’t be able to sell an asset efficiently
(e.g. quickly at a fair price).
22. Systemic Risk
The risk that the entire global financial system or the financial
system of a country will collapse.
23. Concentration Risk
The risk of over-lending to a small number of debtors or investing in a narrow selection of assets.
24. Credit Risk
The risk that a borrower will default on a debt.
25. Fraud Risk
The risk of fraud losses.
26. Accounting Risk
The risk of accounting errors.
27. Fiduciary Breach Risk
The risk that your firm will breach its fiduciary duties
(e.g. insider trading)
Marketing & Sales Risks
30. Revenue Shortfall Risk
The general risk that revenue will fall short.
31. Demand Risk
Lower than expected demand for your products.
32. Market Competition Risk
The risk that competitive forces will reduce revenue (e.g. a price war).
33. Sales Forecast Risk
The risk that sales forecasts will be inaccurate.
34. New Product Development Risk
The risk that new products will fail on the market.
35. Customer Relationship Risk
The risk of damaged relationships will customers.
36. Brand Value Risk
The risk of a decline in brand value.
37. Publicity Risk
The risk of bad publicity.
38. Large Account Risk
The risk of losing a large customer.
39. Location Risk
The risk of choosing a bad location (e.g. a retail location).
40. Infrastructure Risk
Risks related to infrastructure (e.g. electricity outage).
41. Maintenance Risk
Risk of maintenance failure
(e.g. human error in aircraft maintenance).
42. Product Failure Risk
The risk that your product or services will fail.
43. Product Liability Risk
The risk that you will incur legal liability related to your products and services.
44. Operational Quality Risk
The general risk of operational failures (e.g. your website goes down).
45. Production Shortfall Risk
You fail to meet production targets.
46. Logistics Risk
The risk of logistics failure. For example, you fail to deliver goods to your retail locations on time for customers.
47. Procurement Risk
Risks related to procuring goods and services.
48. Architectural Risk
The risk that your architecture will fail to meet business objectives.
49. Data Quality Risk
The risk of poor quality data.
50. Technology Quality Risk
The risk of software and hardware quality problems (e.g. failures, usability issues).
51. Platform Risk
The risk of choosing a technology platform that’s not fit for
52. Information Security Risk
The risk of information security incidents.
53. Workplace Safety Risk
The risk that accidents or poor environment impacts the health of employees.
54. Employer Reputation Risk
The risk that you’ll get a bad reputation as an employer and
find it difficult to recruit top talent.
55. Employer Liability Risk
The risk that you’ll be sued for employment related practices or incidents.
56. Employment Law Compliance Risk
The risk of non-compliance with employment related laws and regulations.
57. Talent Management Risk The risk of losing top talent.
58. Compensation and Benefits Risk
The risk that compensation will be misappropriated (e.g. a manager overpays her sister-in-law).
59. Hiring Risk
The risk that you will hire the wrong candidate or violate recruiting ethics or law.
60. Employee Information Privacy Risk
The risk that you will leak personal information about your employees.
Compliance & Legal Risks
61. Compliance Risk
The risk that you will fail to comply with laws and regulations.
62. Mandatory Reporting Risk
The risk that you will fail to meet regulatory filling
63. Liability Risk The risk of lawsuits.
64. Force Majeure
Acts of nature, war and terrorism.
65. Political Risk
Risk associated with political change.
- Why are they interested
- What makes you believe you and run this business better than me?
- Is this a family undertaking?
- How are you going to evaluate my business and what is your process?
- How are you going to pay for this acquisition
- How quickly are you looking at a being in business
- Is this still the same business that made you get into business in the first place. If not, maybe it is time to let someone else start from where you are leaving off.
- Are you able to withstand more volatility and uncertainty? It is likely to happen before we return to normal. Can you take it?
- Are you the same person you were when you got into business? Life changes a lot and so do you. Are you the same person with the same risk and opportunistic tolerances you once were?
As Derek Sivers said "If it is not a 'hell yes,' it is a no"
Hollar if I can help: email@example.com
Well, the first thing you want to do is have somewhat of a plan to determine how and who is going to be included in that plan. The first thing I would do is, disclose based on seniority. So you would first start with the top tier, management group. Help them understand that they do create the value in the company. It's not you may be transitioning out but the value of the company and what you've built tends to be with them. Now the problem with you need to consider with employees is that there is a lot of concern, they, they watch movies and they're immediately thinking that they're going to be displaced, and that's not the case. So consider them. Consider, who, if there are redundancies in the buyer, if the buyer has, they're going to be moving to a facility or there's overlap, there may be some displacement but, but again, I do believe that it's a matter of transparency rather than just dropping it in on them. So I would look at, look at the employee reassure them that this is a good thing for them it preserves their job not necessarily displaces them the next thing they probably need to address is that culture may change you know the culture is a huge thing these days. You don't know what the next buyer will bring in the way of culture. You can do all the kind of due diligence and get the gut feels and all sorts of things to assess the buyer and what they're going to do. But at the end of the day, you have no idea what your business will look like 12 months from now, but at the end of the day, you do want to address that, your culture may change and it may change for the good so it's it's worth giving that new buyer a shot. And then lastly, I think when you do it is up to you, I think at the end of the day preferably on a Friday where it's more of a celebratory type scenario as opposed to, one day, you're here one day you're not. I think you need to make it a really good thing where you introduce the buyer. Here's why I selected the buyer to sell to; here's kind of the vision, and they have the opportunity to also do their own introductions.
So the business does not look like it used to, and I'm not certain that that's necessarily a bad thing. I'll take our practice, for example. I mean, we the last 30 days, I mean, we have made unbelievable strides in changing how we're doing business. I mean, we're belly to belly business, but at the same time, we're changing too, to accommodate the social distancing. So now, let's move it forward a little bit. Now we have the opportunity to minimize business owners' time; we can do zoom meetings and have an introductory conversation. And that's a good thing. Well, as we look at the innovation that's happened, and even though like, for example, restaurants have taken a tremendous hit, I talked to one restaurant or that, this is a great thing. He is only going to focus on delivery. So he is he is stoked, he doesn't need to pay roughly in his case 8% of revenue to a landlord he can operate in an industrial complex, where rents are roughly, two $3 a square foot. And so any rate, I think it just depends, I think once we see and the dust settles and who is left standing and what their models look like, then we'll be able to determine, what the effect of business value is, but it still ultimately rests on the following. It rests on earnings, it rests on growth, right and expectation and then risk. So, this Coronavirus has done nothing but amplify risk, where are the chinks in the armor in the process. So the new normal and I hate that using that, that cliche word, but you know what is new, maybe better. So, I think we just need to kind of sit tight and see.
Okay, so I do a fair amount of equipment appraisal for the allocation of purchase price for the deals that we do. And my take is like the last recession I mean, there's there were businesses were going out of business and as a result, more equipment was being put on the market so obviously was supply and demand And the values would decrease just simply because there were alternatives to find cheaper equipment elsewhere. And with certainly with the internet and online auctions, it's a lot easier to get better deals. So my take will be that it will, the values of equipment will go down as supply goes up. And regretfully, I hope that I'm wrong, but I don't think I'm going to be on this one. So that I hope that answers it if you need resources on where you might want to sell equipment or how to get equipment valued, certainly reach back out to me.
The chances are that you have developed relationships just merely by being in business. It does create a little bit of a challenge to transfer the relationship to the buyer. There is a risk that is associated with it, and it should be expected that the buyer will mitigate that risk. There are a couple of areas that you should examine, especially if you have contracts with your customers. The first is the assignability. Most customers likely will not assign the contract to a buyer that they have never met. Second, you should examine if the relationship is with you, the business owner, or with your company. It creates a challenge for both. Most sellers believe that the workaround is to sell the stock of the company, which then facilitates the transfer of the contract. Most buyers and their attorneys certainly will frown against that, especially if the amount of due diligence available is limited. Second, the transfer of the relationship is always a challenge and typically is one of the most significant stumbling blocks in selling a company. It creates a challenge for everyone involved to embrace the risk associated with it.
Buyers and their advisors are especially sensitive to environmental issues because it can be an enormous cost for remediation and/or cleanup. As far as your role as a business owner, you should consider the following as red flags:
- You own a dry cleaner, gas station, or other chemicals that could potentially damage the environment
- Your building or the building you lease was built upon the ground that house the business like the aforementioned
- Your building is old in which asbestos or lead-based paint was utilized
if you work in a business where mold may be present
The easiest and cost-effective way to determine whether you have a potential environmental issue is by having a phase 1 environmental study conducted. It is a noninvasive study and will determine whether or not an additional investigation is warranted. Think of it as a drive-by real estate appraisal. It's very limited in scope but may identify red flags to be addressed.
Today's business buyers are engaging equipment appraisers to evaluate the tangible assets. It is always a good idea to make sure that the equipment is in good working order and has life remaining. A buyer will typically identify how much capital expenditure will be required throughout the next several years. The value will be penalized if the asking price is such that it reflects the business that had continued to make capital improvements over the term of ownership.
There are three approaches to value: Asset, Income, and Market. Under the asset approach, the underlying assets are the value of the business. Under the income approach, the tangible and intangible assets are being used by the business to generate earnings. Earnings then are used in forecasts to develop a framework for a forecast and subsequent discounted future earnings analysis. Lastly, the market approach is based on completed sales which include tangible assets. Therefore, when you add assets to business value, you likely will be significantly overstating the value due to double counting.
Regardless of the capital structure, we always assume that the business is leasing the premises. If the business owner owns both the real estate and business and leases it back to him/herself we need to adjust to reflect a rent that is at fair market value that the next owner would have if they leased the premises (regardless if the business and real estate are being sold as a package). If the rent charged is under market value, then the business value will likely be overstated because there are greater earnings. Likewise, if the real estate entity is charging over market rates the business value will be understated. If a business owner owns both the real estate and operating company, they can do what s/he pleases. But to get an accurate reflection of value, adjustments need to be made to market value.
I had the opportunity to review several online calculators. Generally speaking, I believe that as algorithms continue to improve, big data will help people like me make better valuations. The greatest challenge that I see right now is that business owners tend to not understand what's being asked by the calculator and therefore bad information inputted equals bad valuation outputted. Two of the calculators that I have reviewed extensively our BizEquity and the Value Builder System. Both have their faults but are pointed in the right direction to make a considerable impact in starting discussions with business owners. But I will always caution that a business owner needs value guidance regardless of how the number was developed. It does a business owner no good to have a number but not understand how it was calculated and why. Business buyers are astute these days. You have to understand your numbers and your value.
I depends on who the audience is. Certainly you as the business owner need a clear understanding of what creates value in your company and how others might see it. But there are different purposes for the value valuation.
When we look at why you need to understand business value over the 40 years we've been doing sell-side work, the buyer has to have a clear understanding of what they're acquiring and, and likely anyone else that's looking at the business, whether it's a governing body or are a judge or another, needs to recognize how value is calculated. And so, and obviously the beauty's in the eye of the beholder. That's more on the sell-side work. But when you're dealing with the estate and, and, and legal work related to business value, it's based on the principle of substitution. Why w what would induce me to pick one asset over the other? All things being equal. And so the reason behind why I need to understand my business valuation is so you can continue to grow value. And that to me is probably the biggest reason why you need to understand it.
The short answer is yes. I've made a living unwinding a lot of work that business owners have done themselves. But let me tell you the biggest thing that I see is it's not necessarily wrong math, it's wrong inputs. And one of the most common formulas I see is that they'll calculate their earnings or what we, in our world we call 'em seller's discretionary earnings, which is adding to the net income, all your non-cash expenses, which is depreciation, amortization, interest, as well as a direct officer's compensation and discretionary non-recurring expenses. So they calculate that and that that's typically where the, where biggest problem for us is is that they just tend to add everything that they believe the next owner would not need.
That's a challenge because there's a lot of things like for example, advertising, a lot of business owners saying, well, you know what, they, they don't need all the advertising we do. Well. And unless you can quantify how much revenue came from the advertising you did, that buyer is not going to just say, yeah, you know what, that $20,000, I'll just go ahead and add that to your cashflow. It just doesn't work that way. So the next thing is calculating a multiple to, to the earnings that's the next place where it's problematic. So we have to evaluate the industry, we have to evaluate the location of how long it's been in business, what the economic climate for that business is, the size, stability, other areas that affect risk. What are the tangible and underlying assets, any intangible assets, other risks that originate from you, perhaps being only the owner/operator.
And then obviously if there's any kind of real estate, we have to make sure that that real estate is that a rent that's fair market value. And then from there you have a gross value. As you can see, those two areas are the biggest challenges that we bump into is a miscalculation of earnings. And then typically in this case, typically overstating the multiple that you would apply. So as you can imagine, most business owners are overstating the value of their company. And again, going to the market with a high price is not necessarily a bad thing. It just, you don't want to scare off buyers because you know, they assume that you're just hoping that you'll bump into an idiot that will pay that. It just doesn't happen like that anymore.
There's just too much information. There's just too much accessibility to business valuation knowledge. So is there a general valuation formula? Yes, I just gave it to you. I just don't believe that it is probably in your best interest to employ it unless you have some guidance on the inputs of the formula.
Well as I indicated many times, I predominantly do sell-side work. And I help businesses prepare their companies for sale. And when I do it, I'm looking at the market approach. I want to know what companies are selling for or historically have been selling for and, and try to understand what caused those buyers to behave in that fashion. And then from there, I can apply what I've learned through studying completed transactions and apply it to the company I'm working with.
Now on the buy side, the buyers are, are not only looking at what are companies selling for like that, but also the income approach. They want to know what are my returns, how do I get my money back and how do I get a return that's over and above what I can get elsewhere. And as well as if they plan to own and operate it, you know, how do I earn a living on top of the previous two that I mentioned? And so those are the two predominant ones. Based on the wreck, the date of this recording, I would imagine that we'll probably be doing some asset approach value work because of companies that don't survive. This coven 19 mess that we're in. So those are the ones that I use the most is the market approach.
The second one, when we're working with buyers on the buy-side I tend to do the income approach. And then lastly, if the lowest value tends to be asset approach because that's the assemblage of assets.
You can sell your business yourself. You can promote it in a variety of different manners on a variety of different venues. As far as promoting it yourself, you can put it in a newspaper. Depending on the size, if you have a business journal you can advertise it there.
There’s a number of websites you can post to. Here are the most known websites you can check:
One thing that you need to be really sensitive to is confidentiality. If employees are important to you as far as not knowing that your business is for sale, and you probably don’t want them to know, you definitely want to either work through some sort of intermediary whether that’s a broker, investment banker, account attorney, somebody that can insulate you from the marketing that you’re doing for the business.
This is similar to the first question where ‘quick’ is contingent upon the price. Obviously, the lower the price the less decision-making has to happen. When I say ‘decision-making’, I’m referring to due diligence, the scrutiny of financial records and legal documents, things like that.
You can sell a business in the same venue that I mentioned before; print publications, industry publications, trade magazines, business journals, newspapers, and online sources like the websites I mentioned earlier. If you have a larger business you can go to www.axial.net.
In our practice, we always strongly suggest utilizing an intermediary. I always believe that you should have somebody insulating you from the outside world, fielding those questions from buyers, and maintaining confidentiality.
I’m not certain there’s such a thing because there’s always expense in the disposition of an asset. Unfortunately, I don’t think you can do it for free. Now, could you do it yourself? Sure, you can. There’s a lot of content out there about how to sell a business yourself. Again, the biggest challenge that anybody runs into is whether or not you can effectively maintain confidentiality. Keeping the business operating as a going concern while you’re effectively performing an entirely different job serving as the broker, investment banker, etc.
If you are working with a broker, there is a commission that is based on the purchase price I’ve seen anywhere from Lehman which is:
- 5% of the first $1 million of purchase price paid to the seller
- 4% of the second $1 million of purchase price paid to the seller
- 3% of the third $1 million of purchase price paid to the seller
- 2% of the fourth $1 million of purchase price paid to the seller
- 1% of everything above $4 million of purchase price paid to the seller
Or the double Lehman which is:
- 10% of the first $1 million of purchase price paid to the seller
- 8% of the second $1 million of purchase price paid to the seller
- 6% of the third $1 million of purchase price paid to the seller
- 4% of the fourth $1 million of purchase price paid to the seller
- 2% of everything above $4 million of purchase price paid to the seller
Most brokerages from the industry periodicals that I follow get between 10%-12% of the total purchase price. As far as other advisers, legal and accounting, the rough rule of thumb is 1%-3% of the purchase price is paid to those professional advisors. You also have to pay the taxes associated with the sale.
The IBBA and M&A Source Market Pulse
The Main Street of the IBBA and M&A Source Market Pulse is considered $0-$2M in revenue. The Lower Middle Market is considered $2M-$50M. I want you to be sensitive when I’m talking about the main street vs middle market. That’s the delineation. This is done by the IBBA and the M&A Source in conjunction with the Pepperdine Graziadio Business School and Pepperdine Private Capital Markets Project. This is the result of the questionnaire that was sent out in the 4th quarter of 2019 through January 15, 2020. There were 300 business brokers and M&A advisors that responded.
Market Outlook for 2020
Generally speaking, the market outlook is positive for 2020. Advisors expected that deal flow will continue to grow and that multiples will remain constant. As you probably heard in my DealStats episode, market multiples are not changing and they’re not that volatile. The optimism is centered around the greater deal flow, increased exit opportunities for sellers, because of capital there’s an opportunity for business growth, closing rates are increasing, and it’s an election year so we’re probably going to have a pretty good prevailing economic conditions for deal-making.
As we look at the 4th quarter, under half-million dollars in revenue, the average multiples are roughly 2.8 times the adjusted cash between $500K and $1M. That’s average across all industries. The $1M to $2M is 3.3 times in cash flow. And as you move upstream into the middle market, the $2M to $5M is 4.3, and the $5M to $50M is averaging about 5.8.
Size of Business in Revenue
$1M to $2M
$2M to $5M
$5M to $50M
The interesting thing is, as I looked across from 2014 to 2019, there is very little change in multiples at all. The $2M to $5M in revenue drops from 4.6 in 2014 Q4 to 4.3 in 2019. Conversely, the $5M to $50M, we got a 5 multiple in 2014 then 5.8 in 2019.
Time to Close
When we look at the time to close, the average is 8.6 months which is substantially from 2013 which is roughly six and a half months. The rough indication is that it takes 6 months to get from launch to mutually agreed upon to price terms and conditions or a letter of intent. And it takes 2 months from there to close doing due diligence, executing legal documents, financing, and etc.
Going through the size of businesses, the time from launch to close, under half-million dollars in revenue is 7 months, $500K to $1M is 7 months, $1M to $2M is 9 months, $2M to $5M is 9 months, $5M to $50M is 11 months. The average, as I said, is 8.6 months.
Time From Launch to Close
$500K to $1M
$1M to $2M
$2M to $5M
$5M to $50M
That’s a little bit of an increase across all of those revenue thresholds with the biggest one being at a half-million-dollar mark.
From offer to close, under half-million dollars in revenue is 2 months, $500K to $1M is 3 months, $1M to $2M is 3 months, $2M to $5M is 3 months, $5M to $50M is 4 months.
Time From LOI to Close
$500K to $1M
$1M to $2M
$2M to $5M
$5M to $50M
That’s not unexpected either. I think there’s a lot of people that are relying on a lot of professional advisors and it takes time to get that advice. If you are a business owner and you’re looking to sell in 2020 you should probably anticipate that it’s going to be a 9 months adventure.
Based on the poll, the smaller businesses are having challenges securing financing. Believe it or not, in our practice we haven’t seen that at all. Credit is flowing pretty well. But based on the 300 respondents from the survey, here’s the overview:
I’m going to go by Revenue Class and I’m going to talk of Cash at Close, Seller Financing, if there’s an Earn-Out, and any kind of Retained Equity. But let me preface that I haven’t seen anybody retaining any kind of equity 1% or 2%. I may have seen 20% or 25%, but certainly, I have not seen 1% or 2%.
Cash at Close
$500K to $1M
$1M to $2M
$2M to $5M
$5M to $50M
Let’s look at a couple of things:
First, for those of you that don’t know what Earn-Out is, think of it as If-Then Financing. If something happens, then I’m willing to pay you. If I hit a revenue threshold, then I’m willing to pay you X number of dollars over and above what I already paid you.
Next, Seller Financing. It is generally a component of almost all the deals. It’s a way that the buyer can mitigate the risks and keep your attention should there be a challenge post-closing. The only real surprise that I’ve seen that’s inconsistent with what we’ve had in our practice is the $2M to $5M where there’s 15% Seller Financing. We’re seeing maybe 5% Seller Financing, don’t know why, but we have not seen those same numbers.
This is about the seller’s market and the sentiments of 'is it a buyer’s or seller’s market?'. Rather than me pontificate, I’ll just read you what it says:
Seller-market sentiment dipped slightly in the lower middle market this quarter, but advisors still indicate that sellers have a strong advantage across all but the smallest business sector. Excluding businesses valued at less than $500K, advisors have not rated any sector as a buyer’s market since Q3 2017.
Seller sentiment for lower middle market deals remains near record peaks. The downward trend can most likely be attributed to uncertainty due to the upcoming 2020 elections.
2019 Top Industries
Let’s talk about the top industries and what’s selling because I always get that question. In the Main Street category, here’s what makes up the pie chart:
Restaurants and personal services - 33%
Retail - 14%
Business Services - 10%
Construction - 9%
Retail - 14%
Manufacturing - 7%
Wholesale Distribution - 6%
Health Care - 6%
Others - 14%
I think the big surprise to me would be retail and manufacturing is strong. Let’s talk about retail first. Anything that’s going up against Amazon or anything that can be sold online, it seems that there’s a mass exodus away from the behemoth in the retail world. The next one is manufacturing. I would have thought that business owners are moving more toward the market, but that’s not necessarily the case. A lot of the baby boomers that are now 72 or 73, the exit is probably now just reaching their radar and they're now evaluating. I think in the next couple of years we’ll probably see manufacturing be 10% to 15% of the pie chart.
As we look at the Lower Middle Market, here’s what makes up the pie chart:
Manufacturing - 22%
Construction - 17%
Business Services - 14%
Wholesale Distribution - 12%
Health Care - 11%
Information Technology - 6%
Personal Services - 5%
Restaurants - 1%
Others - 12%
The big surprise for me would be construction. It surprises me that it would be that high because I think buyers are scrutinizing deals a little more harshly these days. We all know that there’s bound to be an economic downturn at some point. And to be in a spot where you have a 10-year note with a conventional lending institution and you know full well that in some time during that 10-year period you’re going to face some sort of an economic downturn, it’s a bit surprising. As we look at that, we’re seeing high multiples and construction selling. To me, that’s the big question mark. What’s prompting that? A lot of people are buying market share in anticipation that they want critical mass when the economic downturn occurs. There’s certainly some merit to that but construction here surprised me.
2019 Active Buyers
This is the composition of the buyers that are acquiring companies in the Main Street market:
1st-time buyer - 43%
Serial entrepreneur (high network individuals that are acquiring multiple companies for their portfolio) - 31%
Existing Company (company buying company for strategic acquisition) - 23%
Private Equity platform (company served as required by the private equity group that took it and made it into a platform company) - 1%
Private Equity Add-on (there is a platform company and the private equity bought it and bolted it on to one of their other companies ) - 12%
Other - 1%
This is the composition of the buyers that are acquiring companies in the Lower Middle Market:
1st-time individual - 18%
Serial entrepreneur - 13%
Existing Company - 40%
Private Equity platform - 13%
Private Equity add-on - 12%
Other - 4%
Again, there’s probably no real surprise here either. I guess, if I had a little bit of question it would be I would have thought the Private Equity acquisitions and add-on would have been a little bit higher just by virtue of what we’re seeing as far as the private equity groups dipping a little bit lower into the lower middle market to find deals because they have to deploy capital. It’s just a little bit of a surprise, but then again, the private equity groups are maybe bypassing deal guys and are going right to the business owners themselves and this made it skewed a little bit.
Reasons Sellers Went to Market
Here are the reasons why business owners are selling their businesses in 2019:
Retirement - 48%
Burnout - 14%
New/better opportunity - 11%
Family issues - 7%
Relocating/ moving - 6%
Health - 5%
Recapitalization - 2%
Unsolicited offer - 1%
Other - 6%
I guess what’s surprising for me in this pie chart would be Health. I would have thought that it is a bigger part of this pie chart because as business owners age, health deteriorates, and it’s not something we can dodge. I would have thought at least 15% of the reasons why people are selling will have to do with health.
Exit Planning 2019
Those businesses valued less than half-million dollars, three-quarters of them had no plan. From $500K-$1M, roughly 60% had no plan; $1M-$2M, 64% didn’t have a plan; $2M-$5M, 44% didn’t have a plan; and those over $5M, 25% didn’t have a plan.
No Exit Planning
The bigger the companies, probably the greater the number of advisors. More people are saying, “You know what, you need to plan your sale.” Surprisingly, there’s not much planning. As much as it’s prevalent these days, you can’t go anywhere without someone talking about exit planning. Everybody wants to talk about exit planning.
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If you are considering selling in 2020, you may want to consider doing some formal work as far as getting an idea of where your company is valued at. As I said, it’s taking 9 months to sell, so plan accordingly. If you want to sell in 3 years, a third of that time is being used up in the marketing and sale of your company. And as always, if I can help, let me know.
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 firstname.lastname@example.org 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.
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.