Buy Low, Sell High

/in , /by Exit Strategies

Timing is everything. Almost everyone is familiar with the world’s greatest tip to stock investors, “buy low, sell high.” These simple words of wisdom are equally useful to private business owners; however, sage advice is not always easy to follow in the same moment you’re reaping the benefits of high profitability.

With the current bull market in its eighth year, the lower middle market is economically healthy across many industries. I talk to business owners and CEOs every week. By and large, they are experiencing year over year increases in revenues and profitability – and therefore, exit strategy is one of the last things on their mind.

Selling in an upbeat, healthy economic climate makes sense; at the cost of incremental short-term profits – which are effectively turned over to the acquiring buyer. However, it’s difficult to gauge just how long the bull market will last. A rising tide surely lifts all boats; but it’s wise to consider that tides go in both directions.

There are many factors at play, when contemplating the best time to sell your business. As M&A intermediaries, we see first hand that buyers pay higher valuations for companies that show rising revenue and profits over several years, and when it is reasonable to expect continued growth in the years ahead. And likewise, buyers pay less for companies when the inverse is true.

While many aspects of your business are unpredictable, certain things can be predicted with fairly good accuracy; for example, the movement of tides, and the usefulness of simple stock advice. Buy low, sell high.

Goethe on Exit Planning

/in , /by Al Statz

Early this morning at my Rotary meeting I heard a quote that struck a chord with me. Our speaker, Stephan Stubbins, recounted the story of how he co-founded a successful theater company that helped save one of our local state parks. Once Stephan and his partners quit their jobs and fully committed themselves to starting a theater company, things started to happen for them.

The quote he shared is by Johann Wolfgang von Goethe ( 1749 – 1832) the prolific German writer, scientist and statesman …

“Until one is committed, there is hesitancy, the chance to draw back, always ineffectiveness. Concerning all acts of initiative and creation, there is one elementary truth the ignorance of which kills countless ideas and splendid plans: that the moment one definitely commits oneself, then providence moves too.

All sorts of things occur to help one that would never otherwise have occurred. A whole stream of events issues from the decision, raising in one’s favour all manner of unforeseen incidents, meetings and material assistance which no man could have dreamed would have come his way.

Whatever you can do or dream you can, begin it. Boldness has genius, power and magic in it. Begin it now.”

We’ve all seen how the act of truly committing one’s self to an idea or goal, sets events into motion, some planned and some fortuitous. Committing to an exit plan works that way too.

Thanks for the reminder Stephan! Click here for information on Transcendence Theater Company

Which Business Valuation Will Facilitate Negotiation?

/in , /by Exit Strategies

You are getting ready to sell your business so you must ask yourself some questions:  When do I want to exit?  Who are the most likely buyers?  Is my business adequately prepared to sell?  How does it compare to other like businesses?  And of course, what’s my business worth?

All business valuation relies on some prediction of the future. Business appraisers apply a variety of adjustments to financial statements, theoretical constructs and historical data to divine the future. Numerous valuation approaches and methods are used, but the most common valuation formula is quite simple:

Value = Expected Cash Flow / Risk Adjusted Expected Return

Private equity firms often bypass valuation theory and use their judgment to apply a multiple on adjusted EBITDA (a common but incomplete proxy for cash flow) after scrubbing the financials and gaining a basic understanding of the business.

Likewise, buy-sell agreements often call for a specific price formulas. The advantage in this method is that it’s easy to understand and appears to be a cost-effective way to value a business.

Simplicity is a good thing, except when it conceals or misses important information. For example, let’s say your industry has businesses that have sold between 3-6x EBITDA. How can you understand where your company deserves to be within that range? Not knowing can be costly — either in terms of not getting a deal done because you held out for 8x EBITDA, or because you sold for 3x, when you could have received 5 or 6x.  Improper valuation can easily result in hundreds of thousands or millions of dollars of lost opportunity.

A buyer seeks a reasonable return on their investment, without excess risk. Your task as a seller is to persuade buyers that the cash flow they see will adequately compensate them for the risk of the business. Without a clear understanding the various cash flow adjustments and factors that determine risk, and how that translates to market value, you enter the negotiation unprepared.

A business valuation performed by an experienced professional makes good and common sense. It will help you make better decisions when considering your various exit options.

Make No Mistake: The IRS is Serious About Qualified Appraisals and Appraisers

/in , /by Al Statz
The IRS and the Tax Courts are serious about requiring taxpayers to properly determine the value of non-cash estate assets, gifts and charitable contributions. To avoid having the value of an inherited, gifted or donated privately-held business interest challenged or rejected by the IRS, obtain a qualified business appraisal (valuation) from a qualified business appraiser.
The IRS defines a qualified appraisal as one that:
  1. is performed in accordance with generally accepted appraisal standards;
  2. meets the relevant requirements of IRC Regulations section 1.170A-13(c)(3) and Notice 2006-96, 2006-46 I.R.B. 902;
  3. does not involve an appraisal fee based on a percentage of the appraised value of the property;
  4. includes specific information, such as a property description, terms of the sale agreement, appraiser identification information, date of valuation and valuation methods employed, among other requirements;
  5. in the case of a charitable donation, is made not earlier than 60 days before the property is donated, and in the case of gifted property is as of the date of gift; and
  6. is conducted, prepared, signed, and dated by a “qualified appraiser.” (see below)
Their definition of a qualified appraiser is an individual who:
  1. Has earned an appraisal designation from a recognized professional appraisal organization (such as the ASA, NACVA, IBA, or AICPA) or has met certain minimum education and experience requirements;
  2. Regularly prepares appraisals for which the individual is paid;
  3. Demonstrates verifiable education and experience in valuing the type of property being appraised;
  4. Has not been prohibited from practicing before the IRS under section 330(c) of Title 31 of the United States Code at any time during the three-year period ending on the date of the appraisal; and
  5. Is not an excluded individual (mainly, someone who is the donor or recipient of the property).

In-depth information on determining the fair market value of donated property can be found here, in IRS Publication 561 (Form 8283).  https://www.irs.gov/uac/about-publication-561

Taxpayers and tax practitioners need to pay very close attention to the credentials and experience of the business appraiser they hire, and be sure that the type of analysis and report that the appraiser intends to provide will fully comply with IRS requirements. When you need a business valuation or appraisal for a tax filing, Exit Strategies’ experienced valuation professionals would be happy to help. To discuss your particular business interest and valuation needs with a qualified expert, you can reach Al Statz, ASA, CBA, at 707-781-8580.

Is 2017 a good year to sell my company?

/in , , /by Roy Martinez

Sellers often ask us if it is a good time to sell their business. My response is usually, “yes, but it depends”.  The optimum time to sell a particular business depends on many factors, and this article discusses some of them.

First of all, timing depends on the company:

  • How are its business fundamentals?
  • Is it growing? Flat? Shrinking?
  • Is it profitable? How is the quality of earnings?
  • What is the outlook for the business for the next 5 years?
  • Does the company have a good management team in place if the owner leaves?
  • Does the company have intellectual property? Is it robust? Is it protected?
  • Does the company have concentration risk? Customer, supplier, etc.?
  • How many family members does the company employ?
  • How many personal expenses does the owner run through the business?
  • Is working capital being optimized?

The state of the industry is important too:

  • How are industry fundamentals?
  • Is the industry growing? Flat? Shrinking?
  • Are there industry buyers?
  • Is the industry consolidating?
  • Are there any trends or changes on the horizon that could have an impact (good or bad) on your company?

The economy also matters, and market conditions factor in. When the world, U.S., state or local economy stalls, it can be difficult to sell businesses, at any price. Economic factors include:

  • Is the economy growing? Flat? Shrinking?
  • Is the economy stable? Any risks looming?
  • What is going on with interest rates?
  • What is the status of the Mergers and Acquisitions (M&A) market? Are strategic buyers and Private Equity Groups (PEGs) active or sitting on their wallets?
  • Are lenders lending?
  • At the low end of the market, are individual buyers buying? This may be contra-cyclical. In good times, individuals may not want to leave lucrative jobs. On the flip side, when people lose their jobs, some decide to buy a small business.

Last, but not least, your situation as the owner has a major influence on sale timing:

  • Why sell? Retirement? Illness? Death? Divorce? Burnout? Generally its best to have a good reason.
  • What are you planning to do post-sale?
  • If the business sells at its probable selling price, will you have the funds to support those plans, after taxes? Will you need all cash, or can your provide some seller financing?
  • Are you interested in retaining a stake in the company for investment?
  • Do you have family or management that want or expect to take over the business? Are you willing to leave some money on the table (vs. a strategic sale)?
  • How do you want to be involved with the company after the sale? Is there a time by which you have to be completely out?
  • How important to you are the ongoing success of the company, continued employment of staff, customer or supplier continuity, etc., versus maximizing proceeds?

There are more questions, but this is a good start. The point is, deciding when to sell a business is complex and deserves thoughtful analysis. Some of the answers will be easy, others require more analysis and assistance.

So, is 2017 a good year to sell?

For the first time in a long time, most small-to-medium-sized businesses can look back and see five solid years of financial performance. And, importantly, owners and investors can look forward with an expectation of good years to come. It has taken almost a decade, but most companies have completely shaken off the effects of the Great Recession. Furthermore, in most industries, strategic acquirers, private equity groups and lenders are writing checks and valuations are strong.

So, fundamentally, YES, 2017 is a very good year to sell, in the U.S., in California and in the Bay Area, and in nearly all industries. Of course, the full answer depends upon your specific company and personal circumstances.

Contact Roy Martinez with an immediate need or for further information on exit strategies and the market for your business.

Do investment bankers, M&A advisors and business brokers actually add value? If so, how?

/in , /by Al Statz

Financially savvy company owners, such as private equity groups and diversified public companies, clearly see the value that M&A advisors add, since virtually all of them hire one to run a professional sale process when selling a company in their portfolio — even when they know who the buyers are and which one is likely will pay the highest price.

On the other hand, most entrepreneurs only sell their company once. As a first time seller, they haven’t experienced the value that a capable M&A advisor adds, which puts them at a disadvantage. Fortunately a survey of business sellers by Fairfield University professor Dr. Michael McDonald¹ provides credible evidence that intermediaries add value and explains how. I’ve summarized some of the survey’s findings here.

Professor McDonald surveyed 85 business owners located across the U.S. who sold their companies with the help of investment bankers² for between $10 million and $250 million during the 2011 to 2016 period.

All 85 sellers answered YES to the question of whether their investment banker added value.  As to where they added value, McDonald asked the owners to rate the value and relative importance of 8 services that such intermediaries provide:

  1. Identifying and finding the buyer
  2. Managing the M&A process and strategy
  3. Adding credibility to the seller
  4. Enabling management to focus on running the company during the sale process
  5. Educating and coaching the owners
  6. Negotiating the transaction
  7. Preparing the company for sale
  8. Structuring the transaction

All eight of these services added value according to the owners surveyed.  They said the most valuable services were, “managing the M&A process & strategy”, “structuring the transaction”, and “educating and coaching the owner”.

Importantly, the least valuable service was “identifying and finding the buyer”.  Simply introducing a buyer to a seller is not the primary value that intermediaries bring to the table (though clearly that is still a valuable part of the M&A process).

While this survey focused on $10-250 million deals, its findings hold true for smaller companies as well. If anything, the value that an experienced intermediary brings to owners of smaller businesses is even greater. These owners usually have even fewer internal resources to draw upon and are even more consumed with running their companies than their middle-market counterparts. Partnering with a quality business broker makes even more sense.

¹ I’m using the terms investment banker, M&A advisor, business broker, deal maker and transaction intermediary more or less interchangeably here. Firms that handle only $25 million plus deals usually refer to themselves as investment banks. Firms that mostly sell main street businesses for under $2 million usually call themselves business brokers.  Exit Strategies mostly operates in the $2-50 million price range, and we’ve settled on calling ourselves M&A advisors. Some firms like ours prefer the term “boutique investment bank”, particularly if they serve a few niche industries. When hiring an intermediary, regardless of what they call themselves, it is important to have a good understanding of their knowledge and experience, and the level of service they provide.

² Download the full survey results: The_Value_of_Middle_Market_Investment_Bankers

For more information on Exit Strategies’ full-service sell-side M&A services or to discuss a current need, confidentially, you can reach Al Statz in our Sonoma County California office at 707-781-8580 or alstatz@exitstrategiesgroup.com.

Increase Business Value with Recurring Revenue

/in , /by Exit Strategies

Businesses with a higher percentage of recurring revenue generally sell for higher prices. Recurring revenue business models are highly sought after by strategic and private equity buyers because they are perceived as less risky. Future revenue is more predictable and requires less ongoing sales effort and reinvestment.

Companies like Salesforce.com pioneered recurring revenue in the software world, creating the Software as a Service (or SaaS) model. SaaS turned the traditional software licensing model on its head. Not surprisingly, acquirers of software companies reward sellers who’ve built a low-risk subscription model that looks to them like an annuity stream.

Companies in all industries can increase value with a recurring revenue model. Property management companies sell for more than real estate brokerages, for example, because they have long-term management agreements with landlords and leases with tenants that produce steady monthly revenue. Staffing companies, which place temporary workers with employers and produce annuity-like monthly revenue, sell for more than project based recruiting firms. Distributors who sell primarily proprietary products to OEMs sell for higher multiples than distributors who primarily sell commodities to end-users because high switching costs make customer relationships last much longer.

What percentage of your company’s revenue is recurring? 

Almost any business can find at least one recurring revenue opportunity. A license-based software company for example can add an annual support  program. Almost every boutique wineries has a wine club that automatically ships wines to customers on a monthly or quarterly basis. Restaurants can create loyalty programs that encourage customers to return on a regular basis.

Whether you are planning to exit soon or years from now, we encourage you to consider the immediate cash flow and future valuation benefit of recurring revenue.

Contact us for more information on increasing the predictability of your business revenue to increase enterprise value.

Case Study: How One Entrepreneur’s Advisors Enabled a Successful Estate Transfer

/in , /by Bob Altieri

I recently had a client who wanted to transfer his medical distribution company to his son and retire with peace of mind — a common occurrence these days. Dad and his CPA requested an opinion of Fair Market Value to set the price for a transfer of stock. After I appraised the company (S corp.) stock at $2.0 million, Dad and Son asked me how to finance the transaction. Dad was reluctant to carry a long-term loan for his son — also a common occurrence! Here’s how a team of advisors helped the client make this happen …

The lenders that I approached wanted Son to inject a minimum of $500K (25% of the deal price). This turned out to be a lot more than the son had available. One creative lender suggested that Dad finance the sale for a short time until Son had paid down 25% of the principal on Dad’s note, then return to him for an SBA loan.

The lender proposed 3 seller notes totaling $2 million: Note1 for $500k (25% of the purchase price) for two years, fully amortized; Note2 for $750k with interest-only payments, due in 2 years; and Note3 also interest-only and due in 4 years. The plan was that as soon as Note1 was paid off, the lender would take out Note2 to Dad with a $750k 10-year term loan. Then, after that bank loan was seasoned for 2 years, the lender would lend the remaining $750k to take out Dad’s Note3. The result: Son can acquire the business with no money down, Dad can be completely paid off in 4 years, and Son will have the flexibility of a long-term loan.

When Dad and Son were ready to finalize their agreement, they called a meeting with me and their attorney and CPA. I discovered one significant problem. Under a stock sale, Son’s expected salary and distributions, after taxes, were not quite sufficient to cover his debt service (principal and interest payments) and living expenses in the first two years.  During the meeting, I suggested doing an asset sale-purchase instead of the planned stock deal. In an asset purchase, the Son’s net after-tax cash flow would be substantially increased by the stepped up basis of fixed assets and intangibles. After providing rough calculations, Dad and Son received definitive tax advice from their CPA.

Cash Flow Benefits

Let’s look at an example of the difference in cash flow in an asset sale versus a stock sale.  Assume a $2,000,000 price in both cases, with inventory and fixed assets as shown in the table below, as well as price allocations to covenant not-to-compete and goodwill under an asset sale.

Asset Sale – BuyerStock Sale – Buyer
Inventory$400,000 (not deductible)$400,000 (not deductible)
Fixed Assets$100,000 (new basis)$25,000 (existing basis)
Covenant not-to compete$50,000na
Goodwill$1,450,000na
Buyer’s total deductions against income$1,600,000$25,000
Depreciation of Fixed Assets$20,000 / year, 5 yrs*$5,000 /year, 5 yrs*
CNTC & goodwill combined$100,000 / year, 15 yrs$0
Total deductions, years 1-5$120,000$5,000

*Assume all fixed assets have 5-year depreciation

With an extra $115,000 per year in deductions, and assuming a combined state and federal tax rate of 40%, the Son’s after tax cash flow in an asset purchase would be $46,000 more. Under this structure, the Son’s cash flow would be sufficient to support the debt and enable the ownership transfer.

Dad and Son are now almost a year into their transition. Son is faithfully paying down Note1, the business is doing well, and Dad and Son are happy.

The first moral of this story is that business succession planning and estate planning are team sports, where entrepreneurs need a team of experts to guide them. No single professional is qualified to advise on the range of succession and estate issues that arise.

The planning process often begins with an appraisal of the business and real estate assets, so that tax, financial and legal professionals, lenders, insurers and other team members understand the assets to be transferred. The second moral is that when a business is part of an estate transfer, as in this case, selecting a business appraiser with experience in structuring and financing business sale transactions can be a big advantage!

For further information or to discuss a current need, contact Bob Altieri at ESGI.

Employ a Recurring Revenue Model to Increase the Value of Your Business

/in /by Adam Wiskind

Businesses with recurring revenue are generally more attractive and more valuable to buyers.

Recurring revenue, simply stated, is the portion of a company’s revenue that is highly likely to continue in the future. An effective recurring revenue model creates a “stickier” relationship between the provider of a product or service and the consumer. Those businesses don’t have to spend as much time and money acquiring new customers.

Effective recurring revenue business models:

  1. Consumable -The original recurring revenue business was pioneered by Gillette. Entice consumers to use your inexpensive razors and then perpetually sell them expensive razor blades. Computer printers and coffee makers like Keurig has followed suit achieving substantial profit margins on consumables like printer cartridges and coffee containers.
  2. Subscription – A subscription is a contract to provide a product or service over a period of time, typically annually. Customers are charged for the service or content over the course of the period. Magazine subscriptions and software subscriptions (often called SaaS) fall into this category. There are also many services like janitorial businesses and equipment maintenance businesses that do or could use this model.
  3. Transaction – Credit card companies that take a percentage of every transaction that they originate invented this type of recurring revenue model. However, over the last few years the “sharing economy” has popularized this approach with other successful companies like Uber and AirBnB. These companies charge a small transaction fee to match sellers with buyers.
  4. Rental – Finally, a customer that borrows an asset, such as an apartment, a car, or a tool commits to a recurring charge as long as they continue to borrow the asset. This creates a recurring model as well. Data storage companies and many cloud services such as Drop Box utilize this model.

Why recurring revenue models are attractive to buyers:

  1. Predictability – Businesses that employ a recurring revenue business model, rarely miss monthly or quarterly forecasts because the forecasting models are more accurate. At the beginning of the period, the business starts with a base to grow from rather than beginning from zero. Owners and potential buyers are thus rarely surprised by major fluctuations in results. This predictability has many downstream benefits.
  2. Expense management – Predictability means business owners can manage their expenses more precisely relative to their revenue. One of the challenges with lumpy revenue models is that until the quarter or the year is over, you don’t know how you did. Which means it is difficult to ramp up or down expenses smoothly to match revenues.
  3. Scalability – Recurring revenue model businesses tend to be easier to scale because they produce predictable cash flow to invest in growth. Also, to be successful at generating recurring revenue a business must produce a product or service of consistent quality. Typically, once a product or service has been standardized it is easier to scale the business.

These unique investment benefits make businesses with recurring revenue more valuable than other businesses in the same industry.

With a bit of creativity and planning, many business owners can apply one of the above models to create a recurring revenue stream for their company. If you have questions about recurring revenue business models or are considering an exit, please contact Exit Strategies for a confidential consultation.

Early-Stage Tech Company Exits

/in , /by Exit Strategies

You’ve built a world-class software solution, delivered to customers as a SaaS application or web service.  You’ve recruited a team and created intellectual property. Customer retention is strong and the buzz is growing in your vertical market. Each new customer acquisition represents incremental recurring revenue that falls directly to your bottom line – and the company is closing in on cash flow positive territory.

Could this be the right time to sell the company?

You may be thinking, I’ve barely scratched the surface of the company’s income potential. Why sell at this juncture? The key is that you’ve built the engine for future financial returns. Perhaps a strategic acquirer with more marketing muscle or an existing customer base can turbo charge sales and edge out the competition better than you can on your own.  Or perhaps you’re a serial entrepreneur who’s strength is starting companies, and you’re ready for a new challenge. There could be any number of reasons why selling at this stage makes sense.

When implementing an exit strategy, early stage companies must select the right strategic M&A partner. Start-ups that are short on track record and long on vision and promise represent a unique species in the M&A market. Investment banking firms typically charge hefty fees, and prefer working with larger, later-stage clients.  On the other end of the spectrum, business brokers are generally unaccustomed to working with IP-focused technology clients.  If you’re caught in this under-served market niche, Exit Strategies Group can help. We focus on lower middle market clients, and have the skills and experience to value, package, market, and sell early-stage companies successfully.

One of your first questions will likely be, “what’s my tech start-up worth?”

Factors Affecting Small Tech Company Valuation

  1. Annual revenues and revenue growth rate
  2. How revenues are obtained (licensing fees vs subscription)
  3. Profitability
  4. Customer retention
  5. Strength of management team, and post-acquisition longevity
  6. Growth of the underlying industry
  7. Intellectual property
  8. Technology leadership
  9. Market share
  10. Viral adoption

In 2016, there were several noteworthy deals in the public markets.  While these public company transactions do not reflect how an early-stage privately-held tech company will be valued, it’s interesting to note the relative multiples of these deals:

SellerBuyerRevenuesTransactionRev. Multiple
LinkedInMicrosoft$2B$26.2B13.1
DemandwareSalesforce$2.37M$2.8B11.8
NetSuiteOracle$7.41M$9.3B12.6
Yahoo!Verizon$4.96B$5B1.0

Is it surprising that Yahoo! sold at a 1x revenue multiple while the others sold for at least 11x?  LinkedIn, Demandware, and NetSuite all have growing revenues, defensible IP, in growing market segments. Yahoo! does not.

saasevtorev

Source: Software Equity Group | 2015 Annual Software Industry Financial Report

On average, larger companies (in terms of annual revenue) command higher price/revenue multiples. Price/revenue multiples for small early-stage companies typically range from 1X to 3X (with outliers as low as 0.5X or as high as 10X).

When planning your exit, it’s beneficial to understand the broad range of valuation multiples and influencing factors. The underlying value drivers hold true for all size deals. Consider the valuation factors listed above, and make sure your company is firing on all cylinders.

If you have a $1-50 million revenue early stage software or tech business and you’re planning or considering an exit, please contact one of Exit Strategies’ California-based advisors for a free confidential consultation.