It takes plenty of planning for owners to leave a business on the owner's terms. First, they need to establish their goals. When do they want to exit? Will they sell to a third party? Arrange for their children or key employees/management to take over? What financial return is needed to support their desired lifestyle?
Too often, owners discover that their total business and non-business assets are insufficient to support their desired post-business lifestyle. This “gap” must be closed by increasing business value and cash flow.
Closing the Gap
If an owner needs to close the gap, it makes sense to take steps that will make the business attractive to potential buyers. We call these characteristics “value drivers” and, ideally, they should be in place well before exit planning demands them. If not, given adequate time, they can be selectively implemented. Value drivers reduce business risk, improve profitability and increase the likelihood that the company will continue to operate successfully once the current owner has exited. They can increase cash flow to enable inside buyers to pay the owner’s target price or they can convince third parties to pay top dollar.
Selling to insiders poses an additional challenge, since they typically don’t have much money and can’t borrow any. Here, the increased cash flow the managers create can provide them with the funds to make incremental purchases of equity from the owner. I will elaborate on insider transfer strategies in future posts.
The precise mix of value drivers for any particular company will depend on what the company does. Let’s take a, by no means exhaustive, look at several "generic" value drivers.
Stable, Motivated Management Team
Perhaps the most important value driver is a stable and motivated management team. A business that is dependent on its owner is likely to be unattractive to outside buyers. They will want to know that there is a capable management team in place whose members will remain with the company after the current owner departs. A solid management team suggests to buyers that the company has a strong culture, that important customer relationships are likely to be preserved and that operations will continue to be in good hands.
Since good teams are difficult to build and maintain, it’s worth developing financial strategies that will motivate talent to remain. Consider financial strategies such as incentive compensation systems, cash or stock-based, that reward key employees as the company performs. Such compensation systems should include “golden handcuffs,” such as making significant future rewards contingent on a manager remaining with the company for a specified period of time after the owner departs. Substantial, frequent bonuses that are directly tied to improvements in cash flow or profitability can be highly effective.
Diversified Customer Base
A company that depends on one or two large customers is open to significant risk, one that buyers will likely be unwilling to assume, at least without a hefty reduction in price. In general, no customer should provide over 10 percent of company revenue. Avoiding or correcting such a situation could involve adjustments to the firm’s marketing strategy or sales process. It could mean offering a wider range of products or services or increasing manufacturing capacity in order to serve a broader base.
Realistic Growth Strategy
Potential buyers will demand to see a written business plan that incorporates realistic assumptions regarding the economy, industry trends, competitive advantage and target markets. Owners should have a blueprint that addresses expansion, scalability, potential acquisitions and contingency planning for adverse conditions. Buyers will be looking for recurring revenue that’s resistant to fluctuations in the economy.
Healthy, Increasing Cash Flow
It is often said that “buyers buy cashflow.” A study conducted by U.S. Bank found that 82% of small business failures are due to poor management of cash flow. In fact, all other value drivers are contributors to cash flow, which is a company’s life blood, enabling it to pay bills and salaries, reinvest for growth and shore up resources against future challenges.
While cash flow always matters, it’s critical that it be robust and growing in the years prior to sale, with indications that it will continue to be strong after sale.
Operating Systems that Improve Sustainability of Cash Flows
Proven, replicable processes that generate recurring revenue, increase productivity, cut costs and are supported by industry standard technology are essential to a company’s reliable performance. Successful companies have documented policies and processes that align activities with business plan goals, as well as key performance metrics. The existence of standard procedures and systems demonstrates to a buyer that the business can maintain profitability after the sale.
Efficient Financial Controls
Budgets, cash flow statements, balance sheets, income statements and other reports keep managers apprised of company-wide financial activity, alerting them to issues that need attention. In addition, they tell management how the company’s and their own performance compare to pre-established benchmarks. These documents are also fundamental to a buyer’s due diligence. Effective financial controls protect company assets and support the claim that a company is consistently profitable.
Once the owner identifies which value drivers to focus on, all employees, particularly the chosen successors, should be enlisted in the initiative. Embedding these methods throughout the company helps to ensure that they’ll continue under new ownership. These business “best practices” will contribute to a company’s success at any time, but when implemented as part of an owner’s exit strategy, they can be a decisive factor in closing the gap between a desired purchase price and what potential buyers are willing to pay.