Exit Planning

Examining Available Sale Options and Steps to Maximize the Financial Outcome (Part II of II)

Effective exit planning is essential for business owners to maximize financial outcomes when selling or transferring their business. This second part of the comprehensive guide explores the strategic options available, the timing required for preparation, and key value drivers to enhance sale success.

Read Part I here.

Effective exit planning is essential for business owners to maximize financial outcomes when selling or transferring their business. This comprehensive guide explores the strategic options available, the timing required for preparation, and key value drivers to enhance sale success.

Determining the value drivers for a company is a complex issue and many issues are not only company, but even buyer specific. It is advisable to consult an experienced business appraiser or business broker about three to five years before the desired exit date to find out what might be the best ways to improve the value of your specific company. There are many initiatives a business owner can implement to better prepare their company for a sale and optimize the financial results. Key value drivers during the sale of a company include, but are not limited to: customer diversification, recurring revenue streams, being a big fish in a small pond, spreading know-how across multiple people, positive profit margin trend, having assignment clauses, and getting organized/literally cleaning house.

Getting Organized

The less baggage a company has, the higher the likelihood that a transaction will close and close at an attractive price. In the years leading up to a sale, a business owner should bring their house (company) in order. This includes literally cleaning house because nobody wants to look at a mess and inappropriate posters (think Swimsuit Illustrated) in the locker room or non-compliance with Department of Labor required postings. These types of mishaps will make a buyer suspect that the seller is not running a tight ship and probably has skeletons in the closet. A seller should discuss with an attorney if settling pending or active lawsuits is feasible and if “problematic” employees can be dismissed prior to the sale process.

Financial systems and business records need to be organized and potentially cleaned up. The accounting of a lot of small businesses is not general accepted accounting principles (GAAP) compliant, which can cause issues during the sale process. It pays to engage a professional accounting firm to clean up the financial records prior to a sale. A buyer will ask for many business records during the sale process. Some of which the seller may not have any access to anymore and which, thus, need to be re-issued by governmental institutions. This can take time and should take place before the sale process even starts. An experienced advisor can provide a list of documents that will be needed.

Customer Diversification

A business should try to diversify across industries and geographies, and tie large customers to the company via incentives and barriers. To drive value, no customer should account for more than 10% of revenues and the top three customers combined ideally generate less than 20–25% of revenues.

Obviously, this is a complex issue, as large customers can sometimes be serviced more efficiently, and therefore at a higher profit margin. So having a profitable, long-term customer account for 20% of your revenues is not necessarily all bad. However, if a company is in this situation, it should try to find ways to tie the customer to the company by, for example, offering special incentives in exchange for them agreeing to sign a multi-year contract with you. A while ago, I ran into a printing company that offered its largest customer free plates in exchange for a multi-year contract and the customer agreed right away. More companies than you would think are willing to tie themselves to a supplier in exchange for a good deal. Companies should try to offer something that has real value to their customers but does not really generate significant costs for them. Another idea is to tie them to the business by integrating yourself into their supply chain. A manufacturing company I represented a while ago developed an inventory management software and offered its use to its clients at a very low charge. Many customers signed up and it is now much more difficult for them to switch suppliers as they would lose access to the inventory system. Creating barriers, other than price, that keep customers from leaving is always a good idea and business owners should think about what may make sense for them and their customers.

Also, increasing the diversification of your customer base does not just refer to their share of total revenues. If feasible, a business should also diversify its clients across several industries and expand their geographical diversification. For example, post 9/11, a lot of companies that sold almost exclusively to the airline industry went out of business quickly. A company wants to be in a situation where if one particular industry or customer base takes a hit, it still has enough other customers to fall back on. It is a global world these days, so, if possible, a company should not sell its products and services to just one corner. Few recessions hit worldwide at the same time and with the same intensity. Even the Great Recession that started in 2009 did not affect all global economies to the same degree. So once again, diversification, where it makes sense, is a good idea.

Recurring Revenue Streams

Whether it is due to a multi-year contract or part of the business model, for example if you are a SAAS company, business buyers love recurring revenue. Recurring revenue is the segment of a company’s revenue that is stable and likely to occur on a continuous basis.

Businesses are sold on multiples of revenue and earnings, and the more dollars come from recurring revenue, the more money an owner will get for their company. There are various types of recurring revenue and buyers value them differently. The strongest type of recurring revenue is “contract revenue”, such as a two-year contract you may have signed with your mobile phone provider at some point and cannot get out of without financial penalties.

The next level are revenues generated by monthly subscription services such as Apple iCloud or other providers. While customers can often cancel such subscriptions at any time without a penalty, few do so.

Finally, there are recurring revenues generated from products like razor blades or ink. Gillette sells you the razor at a low price since what they really want is the recurring revenue from the blades. Hewlett Packard does the same with their printers and ink. While customers have no obligation to buy their blades or ink, most customers who purchased their razors or printers will regularly do so.

A few years ago, we worked with a company in the home automation field. At some point, the owner realized that it made more sense for him to offer the installation of an alarm system at or below break-even pricing to his customers since that allowed him to sign them up for an alarm monitoring subscription, which generates a steady monthly income. By switching his focus from making money from the installation of the systems to the monitoring contracts, he ended up increasing his revenues and profitability dramatically in the mid to long term.

Potential buyers of a company will look at the renewal rates of those contracts, so it is important to make sure that customers are kept happy. The higher the renewal rate, the higher the value of the recurring revenue in the event of a sale of the company. If the business in question is a manufacturing company, thinking about ways to add maintenance/service plans to their portfolio makes sense. A company a client recently considered acquiring is a manufacturer of scientific instruments. Next to making money from manufacturing the instruments, they generate significant recurring revenues from servicing them throughout their lifetime.

Being a Big Fish in a Small Pond

A company that is a major player in a smaller market is typically more attractive to potential buyers than a company that is a small player in a larger market. This obviously contradicts the recommendation to diversify your customer base to some degree, but life is never simple, is it?

So yes, you should diversify your customer base, but at the same time, you should strive to define your market and make sure that you become a well-known and substantial entity within it. Strategic buyers tend to pay the highest multiples during the acquisition process; and they typically go after the well-known entities first.

Strategic buyers are also looking to acquire proprietary know-how, so the more of that a company has, the better. Being highly specialized can make a business vulnerable but ideally, it is in a position where it is a well-known specialist in a small field that is attractive to many different potential customers. For example, the business might be a manufacturer of ozone monitoring and controlling equipment. That is a narrow field (small pond) compared to the large pond of scientific instrument manufacturing. Ideally, a business becomes a well-known expert in manufacturing ozone manufacturing and controlling equipment, and then tries to expand its customer base by either geographical or industry diversification.

Spread Know-How

This is crucial for any owner-operated business. In many small businesses, most of the know-how and key customer relationships are focused on a few people. But a business should never be in a situation where the key asset of the company is leaving the building every evening, when the owner is getting in the elevator. Remember that the owner will leave the company as part of the sale process and having all material know-how tied to just them or one or two other employees will make any buyer nervous.

Many sellers underestimate this issue. They think “Well, there will be a transition period during which I can transfer that know-how.” However, a buyer will think “What if the seller gets hit by a bus the week after I bought the business? What if he/she is not cooperative during the transition period? What if key customers simply don’t like me and will move on once the seller has left.” It is important that in the years leading to a sale, business owners start spreading know-how and key customer contacts across a group of employees. The more they spread the know-how, the better, since a buyer knows that realistically a few employees may leave, but it is unlikely that an entire group leaves at the same time. Or in other words, the less the success of the company is tied to the owner/seller, the better. Ideally, all key employees should sign non-disclosure and non-circumvent agreements and sellers may want to consider creating some “golden handcuffs” (payments to key employees if they stay for an agreed upon time post-sale; typically, at least 6–12 months).

Positive Profit Margin Trend

Buyers love a positive trend and the earnings of a company typically have a higher impact on its value than its revenue. In the years leading up to the sale of a company, the focus should be on steadily increasing profit margins. One can achieve this by taking a critical look at the P&L and deciding which expenses one might be able to trim or even get rid of altogether.

The owner should also focus sales efforts on clients with higher profit margins. Driving sales while at the same time recording decreasing profit margins will not do any good. To most buyers, a company with $6 million in revenues and $1,200,000 in profit (20% margin) is more attractive than a company with $7.5 million in revenues and $900,000 in profit (12% margin). The incentive program for the sales team should reward them for winning customers and orders with higher profit margins. The owner should try to obtain financial benchmarking data for their company several years before the sale; for example, by hiring a business appraiser. Knowing the average expenses and margins within one’s industry will tell the owner where they might be able to cut expenses.

Assignment Clauses

Up to about 90% of all small and mid-size businesses (businesses with a value below $10 million) are sold in so-called asset-based transactions. In an asset-based transaction, the buyer acquires only those assets and liabilities that are specified in the purchase and sale agreement. The seller keeps the “legal shell” of the company. There are a variety of reasons why this is happening but what is important to keep in mind is that a business owner will significantly decrease the pool of potential buyers, or at least add significant time to the sale process, if their business has many contracts that cannot be assigned without the consent of the customer. Under commercial law, contracts can automatically be assigned unless the contract specifically restricts or prohibits that. So, when negotiating any key contract, it is important to make sure that it does not have a clause restricting assignment. If a customer insists on restricting assignment, the assignment clause should at least say that “consent cannot be unreasonably withheld.”

The above drivers are just a few of the drivers of business value. There are many others and not every driver applies to every business. However, every single business has key value drivers and identifying and working on them in the years leading up to a sale will always pay off. Their business is often the largest nest egg of a business owner and it is crucial to go through exit planning well ahead of the sale or transfer to assure a desirable outcome.

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Anja Bernier, CBA, CVA, Managing Director of Efficient Evolutions, is an experienced company sale and acquisition adviser. She has experience as an expert witness in Federal Court on business operations and business appraisal related matters. Previously, she has served as Assistant Editor of “Business Appraisal Practice”, the official magazine of the Institute of Business Appraisers (IBA). In addition, she was the President of the National Association of Certified Valuators and Analysts (NACVA) Massachusetts Chapter from 2020–2024. NACVA is one of the largest business appraisal organizations in the world.

Ms. Bernier founded the company in 2005 after spending more than a decade working in marketing, strategic new business development, corporate strategy, and M&A for some of the world’s best known companies, such as Kraft Foods and Dannon (Danone). While reporting directly to the CEO of a privately owned, multi billion dollar European company, she had the sole responsibility for establishing a U.S. subsidiary which involved intensive M&A work.

Ms. Bernier may be contacted at (781) 806-0880 or by e-mail to abernier@efficientevolutions.com.