Traits of a Good Business
Go ahead, say it…we’re stating the obvious here but please bear with us; we need to stress this stuff; it’s almost like a checklist of requirements to sell. You don’t need every one but the more you have…well, you know.
Stable and predictable earnings: Think of revenue and SDE as the first introduction to a buyer. By far, revenue and earnings are the number one attraction. Over the last few years, are there patterns of growth or decline? If in decline, are there good reasons for the decline? The value of a business is directly related to risk and the lower the risk of losing the earnings in a transfer of ownership, the higher the price will be. Buyers are willing to proceed with a transaction when their perception is the earnings are predictable and will not only continue, but also increase in the future. A highly critical factor!
Records: Are your books and records up to date? Are your internal records updated after preparing the tax return? Do you file your taxes on time? Do you use modern software to keep track of sales, expenses and inventory? Answer no to any of these and it will be difficult to sell. In the purchase of a business, a buyer and lender will perform a high level of financial due diligence. If either of them is not comfortable with the review, there will be no deal. Accurate and current financials are critical in determining how the company fares in its industry, amongst competitors and most importantly, verifies what you are claiming. Hint; everything should be electronic. The days of file boxes are long gone. Buyers know that anything that is printed can also be emailed. Demonstrate transparency with electronic records. Also, be prepared to produce interim financial statements. Sometimes called stub or year over year statements, buyers and lenders will want to see how the current year is progressing and comparing the same periods will ease their fears. An example is producing a statement that shows January through June of the current year with a comparison to the same period in the previous year. This really helps if you have a seasonal business. Finally, a note about cash vs accrual statements…if you are on a cash basis system of accounting, make sure to keep access to accrual as well. We commonly see cash-basis tax returns, which are a legitimate tool, but you will also need accrual statements to go along with them. As long as your dates are entered correctly, most financial software (such as QuickBooks) can easily produce both. Records are a highly critical factor.
Management Depth: A strong management team reduces risk thus increases value. Can the company operate without the owner for more than a week or two? Is there good management to fill in while you’re gone? What is the average age of management? Are key managers bound by a non-compete agreement? What levels of experience and education do they possess? Having a good management team is critical to the transferrable value. If a company’s success is reliant on capable, well-trained employees – and not the owner – it means the business will not be negatively impacted under new ownership. Keep in mind, most business buyers are buying a job (which, btw, is not a bad thing) so they can control their own destiny and take pride in ownership. If you’re working key to key, buyers will likely want help in replacing you, which adds costs and decreases value. Simply put, the more the business depends on the owner, the lower the price will be. The best thing you can do is work yourself out of a job. If you are the rainmaker, you can still sell but you should expect to stay with the business for a longer transition period and likely have part of the sale price come later as a contingency payment for customer/client retention. Another important issue is family members. It’s common to have family members working in a small business but how are those positions filled when the business sells? If you have a spouse or child working in the business with you and both want to leave upon sale, have a transition plan in place that ensures continuity. If 2 or more rainmakers plan to leave small business, the buyer pool can dry up. Depth within the staff is a highly critical factor.
Customer Diversity: A broad customer base in which no single customer accounts for more than 5% (up to 10% in some industries) of total revenue helps to insulate a company from financial hardship if a good customer does not stay after a sale. This is easier said than done for some businesses. If the nature of your business sometimes requires large customers, try to have that customer managed by someone other than the owner. Relationships are key in small business and giving a buyer the best opportunity to keep good customers is critical to selling. Customer concentrations are another reason getting part of your price on a contingency basis is likely. Concentrations of revenue are a huge issue when selling!
Barrier to Entry: Buyers want your earnings, not your assets. Anyone can buy furniture, fixtures, equipment, vehicles and inventory and if that’s all it takes to compete with you, someone probably will. The harder it is to get started in your business, the more likely it will sell. A low barrier to entry usually equals a lower price and more difficulty in selling. However, there are steps you can take to help your cause no matter what the industry. For example, create customized software or apps that lower costs and increase customer awareness and satisfaction, develop a process, training and employee manual, maintain drawings or menus for continuity purposes, improve and manage your digital presence, become an industry expert and publish articles and offer training, develop your brand(s), copyrights, trademarks, etc., etc. Any advantage you have over your competition strengthens your position while lowering perceived risk.
Growth Potential: When a Seller can describe realistic growth opportunities, a deal is much more likely. Future growth is the most basic covenant for acquisition and without it; there is no reason to buy. Before going to market, try to identify new products or services that could be delivered to existing customers, study your trade area…would expansion increase margins? Will demand for your product or service increase as technology and population grows? What about adding capacity, can more equipment or staff increase profits? Change is hard when you’re running a small business but identifying new opportunities for a buyer with a new passion will definitely check a box for the buyer and lender. Use caution though…project too much growth and the question becomes “why didn’t you do it if it’s that simple?” You should also use caution in justifying your price with growth potential. If “potential” is what your price is based on, buyers quickly notice you want to be paid for work and value they create in the future. Sorry, but opportunity for growth is a target for the buyer; whoever shoots it down gets the credit.
Facility and Equipment: Are your facilities and equipment well maintained and modern? Old technology, or a disorganized facility or office creates the impression that other aspects of the business, such as financial statements, customer records and employee files may be similarly disorganized and unreliable. Ensure your facility and equipment are organized and in good repair before showing the business as buyers look for opportunities that do not require immediate repair or expansion. A question you will likely face is “what capacity are at now with regard to facility and equipment?” In other words, how much growth can your facility and equipment accommodate? Generally, if you’re operating at 80% of capacity or higher, expect some pushback. It’s also a good idea to get rid of any obsolete equipment or inventory. If something is ready for salvage, move it out and de-clutter. You might also be surprised how far a little fresh paint will go in projecting a clean, positive image. Don’t forget the sign too! Finally, a quick note about excluding equipment from the sale. Generally, if it’s used in the business, it should go with the sale. We sometimes find business owners want to exclude a vehicle or piece of equipment. For example, if the business provides the owner with a vehicle and it’s only used to drive back and forth to work, ok, keep it. However, if the owner uses it for deliveries or to call on clients, it should go with the sale. Buyers and lenders view exclusions as an add to the price.
Loyal Employees: Outside of ownership and management, is there staff that is reliable and capable? Are they considered knowledgeable for your industry? Again, what levels of experience and education do they possess? What is the average length of employment? Do you have low or minimum wage employees? If so, buyers view that as the root cause of employee turnover. A responsible business buyer will be looking for opportunities where the current staff, especially management, will remain in place. Here’s a sensitive matter…have you told the employees you’re selling? We get it, a lot of business owners don’t want their business world to know the business is for sale. Suppliers, competitors, lenders and who knows whom else seem to find this shocking (unless it were their business, right?). Well, truth is all businesses change hands at some point, so it has to be addressed. Points to consider… a buyer will want to talk to key employees before closing to assess retention… yet some employees think a new broom sweeps clean and they will lose their jobs, so they might as well look elsewhere now. Wow, this one’s a bit tough. We find that telling key staff ahead of time is generally the best practice for several reasons. One, it avoids the shock and disappointment you will get if you wait until closing. Dedicated staff with tenure will not appreciate being out of the loop after years of service. Two, if someone decides to leave because of a sale, you know at the beginning rather than finding out right before closing or in front of the buyer. Three, the truth is easy to remember. There will be showings and information requests and making stuff up about your bank or insurance company needing something is a bit weird and rarely fools anyone. A good balance is telling trustworthy key staff but hold off on a company-wide announcement. If important to you, a confidential sale is possible but will add difficulty to the process.
Operating Systems and Procedures: Remember fax machines, file cabinets and Windows XP? Let’s hope they’re a distant memory because they’re obsolete and rarely used anymore. If you still own any of those, you might want to upgrade your tech a bit, say 20 years or so. Buyers want cost effective business systems in place. Old technology and paper offices are expensive to maintain and the margin for error is high. Today’s business apps are inexpensive and effective, especially when compared to manual systems. Your systems and procedure should provide for:
Business performance reports for management that track revenue and expense by product or service.
Inventory and fixed asset control.
A modern, easily found website.
Customer and vendor tracking and communications.
Employee benefit and wage tracking.
New customer identification, solicitation and acquisition.
Proper systems and procedures also help with due diligence and transparency. When buyers and lenders request information and you can provide it quickly and in a convenient format, your business appears organized and well-managed.
Goodwill: Name recognition, customer awareness, location, history, ongoing operations, reputation, and many other factors are all part of goodwill and are already reflected in your earnings. They also greatly influence value. As mentioned, buyers do not want your assets; they want your earnings and the ability to grow the business. Even if the company does not have many hard assets, its relationships are still key and can have significant value. The fact that customers have been with the business a long time does matter. Brand recognition, service or product reliability and high customer satisfaction are distinguishing factors that add value and mitigate perceived risk. Does your business have goodwill? There’s a simple way to check using an old appraisal method (developed by the U.S. Treasury in the 1920’s to compensate distilleries during prohibition). It’s called Excess Earnings and the general theory is earnings over and above a reasonable return on your asset value represents goodwill. For example, if your furniture, fixtures and equipment have an in-place value (not replacement cost) of say $1,000,000 and a reasonable return on that investment is 10%, well, that equals $100,000. If your total adjusted earnings are $300,000, then you have $200,000 to capitalize for goodwill ($300,000 – $100,000 = $200,000). Simple and fun, right? Caution though, the IRS says the method should not be used if there is better evidence from which the value of intangibles can be determined. In other words, they don’t like the method anymore. Btw, if a reasonable return on your assets meets or exceeds your actual earnings, you could be a liquidation candidate and should conduct further studies.
You don’t have to nail each one of the traits but the more your business can hit, the more likely a sale. If taken as a whole, you can see buyers want earnings, a livable wage and satisfaction from operating a clean, modern business.
The 5 Basic Questions
A good Business can answer the following questions with ease.
1. What’s for sale?
2. Why’s it for sale?
3. How was the price determined?
4. What financing is available?
5. What’s the opportunity?