Exit Planning Tools for Business Owners

small business

Quality of Earnings Part 2: Hidden Expenses

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In my last post we discussed quality of earnings audits from a revenue perspective. Customer concentration, marginal lines of business and contracts are the three most common revenue traps. If you are comfortable with your company’s strength and stability as regards to revenue, it’s time to look at your expenses.

There are two expense categories that trip up owners in due diligence, one-time (out of the ordinary) expenses, and unrecognized liabilities.

One Time Expenses

A few years ago I worked with a client who owned a wholesale distribution business. He presented his financial statements to me to determine the practicality of obtaining third-party financing for an employee buyout. His recast statements showed over 10% free cash flow after owner compensation. That’s a respectable number in most wholesale distribution business.

As I examined the prior year’s financial records, I noticed that the adding back of a one-time expense accounted for almost 75% of the cash flow. I inquired, and found that the expense was for a conversion of the company’s enterprise information system, including consultants’ and employee costs for implementation.

Digging further, I found that 50% of the prior year’s adjusted cash flow number resulted from reversing a one-time expense associated with converting the delivery fleet from owned to leased vehicles. The year before that, half of the cash flow came from a one-time manufacturer’s buyout of some inventory, which was replaced under generous payment terms.

There are legitimate reasons to account for one-time expenses, and doing so can give a better picture of a company’s ability to make money. When there are such add-backs year after year, however, it begins to look like an attempt to count normal operating costs as profit. The bank determined that the company did not produce sufficiently dependable cash flow to finance the LBO debt.

This is a case where a lender was considering profitability, but the same rules apply to buyers. It’s hard to sell someone on applying a multiple to profits that have never actually been produced.

Unrecognized Liabilities

The other expense category that will impact the quality of earnings opinion is unfunded liabilities. These most frequently are unearthed in employee benefits and service agreements.

The first is accrued vacation or PTO. It is customary to keep records of this liability off the balance sheet, but professional buyers don’t see it that way. The benefit was earned while producing for the seller. They buyer has no reason to pay it out for work that wasn’t done for him.

Pension benefits are another area replete with land mines. Don’t try to show earnings that would otherwise have been shared through an employee profit-sharing plan. A buyer will insist (rightly) than future profits should maintain traditional benefit levels.

Sloppy plan administration is also a liability. If your 401K, for instance, has a backlog of orphan accounts or other potential compliance issues, expect fixing them to be considered as acquisition costs in negotiations.

Do you have annual service agreements with your customers? The appropriate accounting method is to amortize the income over the life of the agreement. Many smaller businesses, who keep records on a cash basis, recognize the income as it is received. That may lead to adjustments in earnings.

Expect that quality of earnings auditors to also look at the service flow through the agreement. If you expend a lot of effort at the end or the contract (say to update software of position for a contract renewal) they may want to accelerate recognition of those expenses.

Not Done Yet

Remember, a quality of earnings examination has one purpose; to find areas where a purchase price merits deductions. The firms hired for these reviews command five and six figure fees for the work. They are expected to produce savings in proportion to their fees.

When you’ve run the quality of earnings gauntlet of your revenue and expenses, you’re not done yet. We have one more challenge; cash flow adjustments.  More on those in the next post.

Your Exit Map, Navigating the Boomer Bust is now available on Amazon, Barnes & Noble and wherever books are sold.

With over 300 illustrations including pictures, graphs, charts and cartoons, it is a completely different approach to exit planning books.

Your Exit Map is ranked the #1 new release in its category on Amazon, and is supplemented by free tools and educational materials at www.YourExitMap.com.

Quality of Earnings Part 1: Revenue Traps

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This will be the first of several columns on quality of earnings. While a formal, third-party Quality of Earnings Study is more often seen in mid-market transactions, even small business owners should be aware of the factors that can cause discounts to a selling price long after they thought it was settled.

There are few things as exciting as receiving a Letter of Intent to purchase your company. It may specify a dollar amount, or (as often happens with Private Equity Groups or PEGS) it may set a target range for a price based on multiples of profit. The exact profit, or earnings, that will be multiplied to calculate the price may seem obvious to you, but you shouldn’t be too sure.

Every letter of intent has a clause subjecting the transaction to due diligence. Most sellers are unconcerned about the diligence process. They’ve run a clean set of books. The assets listed on their tax returns are present and accounted for. Revenue and expenses are recorded accurately. A quality of earnings study, however, will look deeper than that.

We’ll look at earnings quality as it is affected by revenue, expense and cash flow factors. First, we will look at revenue-related issues.

Customer concentration

The first, and often the biggest item affecting purchase price is the presence of one or more key customers, without whom the business would have to downsize its operations. Just as stock pickers look at a public company’s beta, or risk factor, large customers are the chief beta influence on the value of privately held businesses.

A single customer who accounts for 10% of your business may not warrant a price discount, but one who controls 20% or more of your revenue almost certainly will trigger renegotiation. You may have a decades-long friendship with that business, but a buyer has little confidence that he or she can maintain the same relationship.

Instead of accepting a discount, you may want to offer your services in transitioning the account. Consider making some of the original price contingent on a an agreed measurement for a successful transfer.

Revenue by line or service

Most businesses do or sell more than one thing. I see this when we try to assign a National American Industry Classification System (NAICS) code to a client for valuation purposes. Many companies sell a product, but also offer service and repair. Some provide skills in several similar, but different industries. Others may have entire departments or divisions that work almost autonomously.

A quality of earnings study (their practitioners don’t call them “audits” although almost everyone else does), will parse revenue and profit by line of business. If 75% of your employees are engaged in something that provides 30% of the profits, you may be looking at another attempt to reduce the purchase price.

Contracts

This area has two components that are subject to due diligence; where you have contracts, and where you don’t.

If you don’t have written agreement with both vendors and customers, expect more strenuous examination of those relationships. How are price changes handled? What if the other party unilaterally changes payment terms? Do you carry inventory that is for a specific account, without any guarantees that it will be purchased? Can your right to distribute a product be terminated without recourse?

I was recently given the opportunity to prepare a family business for a third-party sale offering. It made white-label commodity products, and owed 75% of its revenue to one, publicly traded customer. That customer had given them orders consistently for the last 40 years, but refused to sign any agreements, project future needs, or buy in any way other than one P.O. at a time, as needed. I declined the engagement.

If you do have contracts, expect them to be examined diligently (thus the term) for dangers. While specific purchasing terms are desirable in any agreement, look them over before you start the sale process. See if they should to be updated to reflect current practice. Often conditions and processes have changed by verbal agreement, but that can be tough to explain to someone who is holding a contract in hand that doesn’t match your actual business relationship.

Contracts with public entities or large corporations may also have “change of control” provisions. These call for cancellation or automatic rebid of the business if the supplier changes. In some cases this is a key reason to consider a sale of stock, rather than assets.

First revenues, then expenses

Whether or not your buyer gets a professional quality of earnings study, these are factors that will trip you up in the due diligence process. Next time we will look at how recorded and unrecorded liabilities affect a purchase price.

Exiting a Family Business: Three Questions

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Transitioning a Family Business has special issues. This interview was reprinted last week in the newsletter of Steven Bankler, CPA.

We asked San Antonio business consultant John F. Dini, one of the nation’s leading experts on business ownership and exit planning, for his advice on handing down the family business. As the author of Hunting in a Farmer’s World, Beating the Boomer Bust and 11 Things You Absolutely Need to Know About Selling Your Business, Dini literally “wrote the book” on succession planning. He recommends that Baby Boomers and other business owners with an eye on retirement carefully consider the following questions.

What will your role in the company be?

Dini says that many owners “hand off” their companies without a real succession plan, especially when the business is destined to stay in the family. In those cases, ownership is often passed on while control remains—officially or unofficially—in the hands of the original owner, which can cause significant problems.

“Discuss what you want your level of activity to be, and what your successors think it should be,” he advises.  “Keeping your old office, or showing up every day to ‘just check on things,’ cripples your successor’s authority and ability to implement his or her own vision for the business.”

Is your successor ready, willing and able to handle change?

Many second-generation owners are indoctrinated to run the business exactly as they were taught.  However, as Dini points out, that may not be the best course of action.

“Markets, products and technology evolve,” he says, recommending that you consider: “Is your successor ready to adjust to changes in the business? Does he or she have any experience in dealing with major disruptions, such as the loss of a key customer or employee?”

Also understand that you cannot replicate your own mix of skills and talents in a successor, especially when it comes to the experience and “battle scars” you’ve gained along your entrepreneurial journey.

“It’s often impossible to train a successor as a ‘utility infielder’ who can handle finance, operations and sales,” Dini explains. “If key employees are critical to supplement certain areas of running the business, they should be included in a family business succession plan with long-term incentives for retention.”

Does the company have the financial strength to thrive without your personal signature?

“As a family business expands, an owner’s ability to personally guaranty its liabilities usually grows with it,” cautions Dini. He recommends taking an honest, comprehensive look at how your departure will affect finances from both the business and personal sides.

“Can the company maintain necessary credit facilities if you don’t back them up? If not, consider talking to your bank about how to limit your exposure,” he advises. “Many parents have lost their savings because they stopped watching the business until the calls started coming from its creditors.”

Succession in family businesses is often a balancing act between the desire to give the children appropriate freedom to run the company and protecting the assets of the parents. Planning should encompass timing, authority and financial responsibility, with all parties agreeing on the parameters.

Do you know the owner of a family business? Please share!

The Unsellable Company

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What does an unsellable company look like? Some business brokers will assert that there is a buyer for any business. That may be true, but historically four out of every five small businesses listed for sale fail to sell.

In this post I am specifically discussing profitable Main Street businesses. That is loosely defined as those valued at under $3,000,000. “Small” doesn’t necessarily refer to size. Some low margin businesses, such as those in distribution of commodity products, could have revenue well into eight figures and still be not command a $3 million valuation.

Others, like those with proprietary software, might have a few million dollars in revenue and be snapped up by a strategic buyer for an eight figure price.

The buyers for most Main Street businesses are individuals who are seeking a livelihood. They usually have never owned a business, and are betting their life savings on the venture. It’s not surprising that they are nervous.

The price ceiling on defining a Main Street company is based on the projected ownership. Simply put, if a business’ principle purpose is to provide an owner (or perhaps a few owners) with a decent standard of living, the ceiling on valuation is based on what the company’s cash flow can support in owner salary, debt service and ROI on the down payment.

To see if your presumed value supports these three requirements, try the Valuation Sanity Check at http://yourexitmap.com/exit-planning-valuation-sanity-check/.

Just because your cash flow justifies your price however, doesn’t mean your company is saleable (or as my Canadian friend John Warrillow writes it in Built to Sell, sellable.) There are still a number of reasons why a solidly profitable business may not find a buyer.

Owner Centricity

Simply put, the whole business revolves around you.  A buyer’s due diligence keeps running into you at the end of every question. How do you do this? (Ask Bob.) Who are your most important customers? (Ask Bob.) What discounts are available from your suppliers? (Ask Bob.) You get the picture.

Even if you have excellent processes, duplicable talents and widespread delegation, an owner who personally holds the professional license needed to legally operate presents a similar issue for a buyer.

Customer Concentration

Some small businesses are very good at what they do, but luck always plays a part. If you’ve grown by depending on one customer for over 50% or your business, or a handful of customers for 80%, expect individual buyers to shy away.

Long term relationships are great, but if they aren’t documented don’t expect them to carry much weight in a valuation. It’s one thing to be proud of doing business on a handshake. It’s another to bet your life savings on one.

Uncertain Revenues or Margins

If you have to explain your tax returns with “We have some good years and some bad years,” you will have a problem attracting buyers. They don’t have your confidence that a bad year will be followed by a good one. If they are committing their retirement savings to the purchase (which is often the case) they are worried about having the financial stamina to withstand a dip in sales.

Similarly, it you are regularly buttressing your revenues with cuts in margin through big discounts or volume deals, it will be perceived by a prospective buyer as regularly having to “save” the business.

You may have steadily increasing revenues and profits, but companies that bid, or have to submit proposals for each job, strike fear into the hearts of inexperienced buyers. They have nightmares about failing to win another job from the day they take over.

Contracts help with this, but they often aren’t enough. I worked with one buyer whose offer was based on the revenue stream from each existing contract until it expired. He wanted to be made whole for the purchase price even if he proved unable to ever land another big customer.

The Unsellable Company

If you recognize your business as having any of these traits, you have three choices when it comes to exit planning.

You can sell the company to employees who understand the constraints of the business and are comfortable with them. You can list the company for sale anyway, and hope that yours is among the 20% of enterprises for whom the right buyer can be found.

Finally, you can implement a plan to eliminate the obstacles to a sale.

A Transition to Exit Planning

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It is time for a new direction. This marks my 400th posting to this site. I’ve enjoyed writing weekly about the daily issues and opportunities of business owners for almost ten years, but it is time for a change.

Awake at 2 o’clock has a new look and new navigation, although we decided to keep the title, logo and banner. More about that in a bit. First the why behind the change.

Regular readers may have noticed that, over the last year, I have been turning more frequently to exit planning subjects. That reflects my own career progress.

Before 2007 I sold businesses as a certified business broker, and helped numerous owners through transition as an executive coach. That year I wrote my first exit-related article (titled “Boomer Bust?”) for the business journal.

My research for that piece convinced me that there was a seismic event on the way in the retirement of the Boomers. I also learned why they were the most entrepreneurial and competitive generation in history. I hadn’t yet heard the term “exit planning”, but I was already thinking about the advisory help I knew would be needed.

I certified as an Exit Planner (CExP) in 2011, and gave up my Business Brokerage practice in the same year. In 2012 I published a new edition of my first book 11 Things You Absolutely Need to Know about Selling Your Business, and began speaking about “Beating the Boomer Bust” to audiences nationally.

In 2013 I published the award-winning book, Hunting in a Farmer’s World, which looks at the psyche of business owners, including their challenges when leaving their businesses.

I also developed an online product, The ExitMap®, to help owners and their advisors begin conversations about exit planning. It is based on my coaching experience with hundreds of owners and fills a gap left by the more technical/financial assessments that currently dominate the market. We’ve built a national network of professionals, experts in multiple disciplines, who are committed to exiting owners’ need for skilled and experienced help.

Finally, in 2016 I chose not to renew my 20-year franchise with The Alternative Board® in order to concentrate on helping owners leave their businesses. In the last decade I’ve progressed from not fully understanding the term “exit planning” to practicing it full time.

This year I will publish my new book, Your Exit Map: Navigating the Boomer Bust, which is accompanied by an online library of resources for business owners at www.yourexitmap.com . It has turned into more than a consulting skill. The millions of transitioning Boomers who need assistance have become my calling.

People ask me all the time, “Why is your blog called Awake at 2 o’clock?” Most business owners understand the reference to those nights when you can’t sleep because you are thinking about the business. It seems appropriate to keep the title when considering the biggest single financial transaction in most owners’ careers; the sale of their businesses.

We have a new tag line: Plan…Build…Exit…Enjoy. It describes both the path to a successful transition as well as the four topic areas we will discuss in this space.

Plan

Exit Strategies. These articles will focus on the big picture. What do you need to know in order to prepare well and successfully implement a lucrative transfer of the business? What do the acquisition markets look like? How do current events impact your time frame or financial objectives?

Build

Improving Value. Enhancing the value of your business takes on new importance when you are looking at cashing out. How do you secure employees and customers? How do systems and processes affect your sale price? What specific areas of improvement will make your business more attractive?

Exit

Exit Options. Should you be targeting a specific segment of the buyer market? How can that be accomplished? What technical issues will you face with taxation, negotiation and contract structure? The specific and unique challenges of Family, Employee and Third-Party sales.

Enjoy

Exit PlanningLife After the Business. The purpose of exit planning is to…EXIT! In collecting reader recommendations for my latest book, the most frequently submitted suggestion was to include discussions of the ways people enjoy their post-ownership lives (or don’t.) We’ll collect real-life stories and share them.

I plan to mix up my approach a little more. Instead of merely relating my observations and experience about ownership, I will invite guest bloggers, review new books on exiting, and interview entrepreneurs about their own experiences. If it will help business owners who are planning the next stage of life, it belongs here.

I will post when I have something worthwhile to share. Since the subject matter is more focused, I will no longer have the flexibility to post every week on whatever topic appeals to me. A little discipline never hurt.

Finally, in a world where content is paramount, we aren’t discarding the 200,000 or so words already cached on this site. You can still search by topic for any past posts.

I know that some subscribers are not planning their exits right now, but I encourage you to stick around. Sooner or later every owner leaves his or her business. Expanding your knowledge about the process now will prove handy down the road. Your exit planning objectives should be influencing how you run your company today.

I am very excited about this new direction and plan to continue writing with the same passion and enjoyment that has fueled this column since 2008. As always, thank you for reading!

John F. Dini, CMBA, CExP