Losing Sight of the Big Picture is Easy to Do
Challenge: To Recognize the True Value of an Acquisition, Not Just Focusing on Today
TVG represented a project-based business that had a few million dollars in current backlog. This backlog represented over 100% of the current yearly revenue. When we went to market, our valuation was based on several factors including the historical cash-flow as well as the strength of the future backlog. The buyers agreed to the valuation in the Letter of Intent (LOI), but during the due-diligence period, the buyers got lost in the minutiae and tried to negotiate a lower price. The sellers were ready to retire but did not want a “fire sale” either. The buyers took the sellers’ desire for a quick sale as a weakness and tried several different ways to reduce the price.
Approach: Confidence in the TVG Valuation
TVG was confident in the valuation that we prepared and felt this was a fair yet aggressive price for this business. There were many existing positive attributes of the business that were addressed clearly in the valuation for the buyer to have the full picture of the selling company.
Finally, the seller was tired of the buyer’s indecisiveness and attempts to tear down the agreed upon price. The seller was ready to terminate the LOI and find another buyer. TVG understood the seller’s frustration. We discussed with the seller how we would make the buyer see reason and urged them to give the buyer another chance. TVG then went to the buyers and very bluntly explained to them that they were days away from the seller walking away from this deal. We showed them the solid facts that they would be missing a huge opportunity because they were trying to shave off a few dollars. The price of the deal was more than fair. On top of that, the value that this particular buyer would be able to bring to the company very quickly would more than make up for the feeling of overpaying for the company.
Result: Buyer Agreed to Honor the Original LOI
The deal was able to close in a relatively close proximity to the original closing schedule. Nine (9) months after the close, TVG followed up with the new buyers. The business had grown 25% in less than nine (9) months, and the new owner offered thanks and apologies for breaking down during the due diligence process.
Knowing and Understanding ODCF – Owner’s Discretionary Cash Flow
It cannot be stressed enough the importance of verifiable cash flow on a small business.
Replacing an income from corporate America is the main drive for a high percentage of first-time buyers. They are typically looking for a small business to “cut their teeth on” for their first or only business purchase.
What is ODCF?
ODCF stands for Owner’s Discretionary Cash Flow, which is simply defined as money able to be taken out of the business annually.
Why is it important to know about the seller’s ODCF?
A high percentage of first-time buyers come from retiring corporate America. Knowing what the seller is considering as ODCF will allow the buyer to know whether they will be able to immediately supplement their previous salary with the business income without dipping into operating costs. It is not just the owner’s salary that is considered ODCF, in fact, this number is often reduced so not to be overly double taxed with payroll taxes as an employee and an employer. There are many categories that can fall into this bucket on a balance sheet.
Main elements that comprise the owner’s discretionary cash flow will include:
Net Income – The amount of revenue after paying all business expenses and before federal taxes have been paid. This can fluctuate to keep taxes down. Though prepaying expenses for a coming year might reduce the net income, it does not mean that the business is not profitable.
Owner Salary – This is not always a large amount as to not overly double tax as an employee and an employer.
Depreciation / Amortization – This is added to ODCF as these things reduce taxes as it decreases taxable income.
Interest Expense – This is not a category that is often taken over by the new owners. All previous owner loans and such type expenses should mostly if not completely be eliminated with the business transfer.
Non-Reoccurring Expense – This is a varying amount as the category suggests. However, it is important to see if the balance sheet can sustain this type of ODCF should the need arise.
Owner’s Perks – This is a common way to offset an owner’s salary. It can include things such as auto expenses, cell phones, travel, insurance and 401(k) contributions.
This overall ODCF amount may end up making a small business more appealing, but make sure it is all well documented.
How does ODCF affect the sale or purchase of a business?
Though it is true that many items can fall into the category of ODCF, a bank may not see it in the same light. This is not as much of an issue if the main financing for the business is seller-financed or the seller kept ODCF to just the basics of owner salary. An SBA or conventional bank will have other regulations to adhere to. Sometimes the only thing a bank will consider when making a determination to fund a business transfer is the EBITDA plus the owner’s salary.
Selling a Business – Woes to Heroes
Challenge: Reporting Financials / Partner Disputes
Due to partnership conflicts, a client went from being a passive minority investor to an active majority owner in a short amount of time. This was in an industry where they had limited knowledge. To further complicate the selling process, late paying customers and a non-traditional accounting approach made year-end financials appear drastically different from the health of the business, which would cause great pause for lenders. Given that a majority of business transfer deals are financed through some type of third-party financing, and saddled with the financial limitations of the company, it was obvious that the buyer pool could be limited, which in turn could increase the time to close. However, the seller was anxious to sell quickly, so we had to balance the seller, the business hurdles, and marketplace.
Approach: Expanded Deal Structure / Demonstrated Value
Established Expectations – Because of the late-paying customer and non-traditional accounting methods, we understood the lending climate would be limited at best if not non-existent. For this reason, we informed the seller that a significant amount of seller financing would potentially be involved. We provided an estimate of value as well as an expected deal structure before engagement ensuring the seller would be open to all types of offers and to lay the foundation that a full-price all-cash offer would be the exception and not the norm.
Told the Story – While every buyer could see the financials were on a decline, the company still had some great assets. 1) The company still had multiple strong accounts, 2) they were focused in a very niche industry within the IT sector, and 3) they still had multiple channels of revenue. The core of the company was still intact and with a focused growth strategy, a new buyer could easily return the company to producing higher revenues.
Focused Marketing Search – Given the issues of the company, we understood a generic buyer probably would not be the best buyer to target. We knew we either needed a strategic partner who understood the assets of the company and could create synergies or an IT professional who wanted to run his own operation.
Received 3 competing offers | Closed in 4 ½ months | Seller received 94% of asking price
- An IT professional purchased the company using a ROBS (Rollover for Business Startups).
- The purchase price comprised of equity from the buyer and a seller note.
- Since no outside banks were used, we were able to have a quick close and save time.
Unlock Your Business’s Potential
The value of a small business is primarily driven by its profitability. In most small businesses, there are numerous opportunities to enhance revenues, increase gross margins, and reduce costs. Improvements in each of these areas can result in significant increases in the value of your business. For many small businesses, every dollar in increased profitability will produce approximately three dollars in increased business valuation.
Many small business owners do not have the capability to re-evaluate their whole business on their own. However, a quick way to start, if an advisor is not in the budget is to look at a business’s waste. This can be in the form of raw materials or time. A reduction in waste almost always directly correlates to a reduction in costs and an increase in revenue. Looking at a business from this perspective often leads to other insights for process improvements resulting in higher revenue.
Although many changes can be made quickly, to maximize the benefits of the business sale process, the improved profitability has to be reflected in the financial statements for at least two (2) years before the sale. In other words, if you begin to implement changes only three (3) months before selling, the business valuation will not reflect the positive changes of your last three (3) months. It is never too early to implement profitability improvement efforts, but it is best to try to do so at least four (4) to five (5) years in advance of a business sale.
To gain a better understanding of how small businesses can improve their margins thus improving their business valuations, please consider reading this article: 5 Simple Ways to Improve Your Profit Margins
The first step in the right direction is deciding to use a business broker because you don’t know what you don’t know!
Ask questions, expect questions and review standard documentation.
Be Bold and Ask Questions
This is your business and selling it should be handled professionally and with transparency.
Credentials such as being affiliated with the national IBBA and local state associations such as TABB in Texas are marks of a knowledgeable broker. However, this information is not always right out in the open. Ask if they have any affiliations. If they are not of these, look up the ones they provide.
Prior business ownership, regardless of the exact type of business, is a foundation of understanding from both sides of the process. Though not necessary, our firm believes in having that connection to better facilitate the transfer.
Expect and be Ready to Answer Questions
The right broker will have a solid understanding of financial analysis and more specifically, an explanation of their own financial analysis process. If they cannot do this…walk away. The first meeting should include them asking you about your business’s financial health and how they plan to market to the right buyers. They should be able to explain these two topics logically and ethically. If they cannot do this…run away. This is not an area of “feeling” the numbers but rather there should be a clear and coherent way they can explain to the seller how they plan to market a business for the price that is dictated by financial and transparent market analysis. From this, options for the deal structure should be presented. The seller should not be railroaded into one plan of attack. Ask about past closed deals and how they were closed, especially for ones that mimic the current company for sale.
First Impressions Really Do Matter
When meeting a prospective buyer, will your business broker be presentable? Will the location or office? Set up a meeting early on to see what the prospective buyer will see. During your meeting, do not be afraid to ask for copies of blank documents such as LOIs, Listing Agreements, Confidentiality Agreements (CA) and Sample Marketing Packages/Plans. These can make or break a deal before negotiations begin. Are they visually presentable? Do they contain viable and valuable content for the buyer?
A major topic of your first meeting or even prior to your first meeting should be that of confidentiality. The broker should initiate this conversation early on. The timing of when it is brought up is indicative of how it is handled in general throughout a deal and even after a deal is closed.
To choose the right business broker to sell your business, be prepared with your questions and with the deliverables the broker should bring up to you. If you cannot check off those boxes in your first meeting, continue your business broker search.
To learn more about choosing the right broker for you, get EXIT – A Business Owner’s Guide To Selling a Company, by Alex Vantarakis.