Learning how to exit a business is just as important as starting one. In this episode, host Domenic Rinaldi gives out the three foundational components that you, as a business owner, must see through to ensure that you are ready to sell your business and do it with success. Grab a pen and paper and take down notes. Consider these things well as soon as possible because some are going to take some time to pull together.
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The Three Foundational Components Of Selling A Business
I’m going to take some time to talk about the three foundational components that go into an owner of a business being ready to sell their business. Before I do that, we’d like to reference one of the first episodes of 2020, Dr. Bart Basi. If you haven’t had a chance to read that episode, please go back and read for both buyers and sellers. If you’re an accountant or an attorney, and you haven’t checked that out, Dr. Basi, who is an expert at all tax matters related to M&A transactions, gave some tremendous information. He gave lots of examples of where he has been able to save people hundreds of thousands of dollars and in many cases, millions of dollars on their transactions through understanding tax code, and how to properly set up either an acquisition or sale of a business.
I referenced in that interview a deal that he was involved in with us where we had a C-corporation as a sell-side client, and we had looked at the tax ramifications of that deal with the client’s accountant. The tax rate that came back was somewhere in the 54% range. We thought that there was another way to structure that deal. We contacted Dr. Basi, he came in and looked at that transaction. We got the effective rate down to the low twenties. I saved our client hundreds almost $1 million in taxes, a credible outcome for our clients. It was a great episode and I highly recommend talking to Dr. Basi if you’re thinking about buying or selling and structuring the proper deal.
I wanted to launch into the three main components that owners of businesses should be considering well in advance of a sale of a business because some of these pieces are going to take some time to pull together. When clients come to us and our firm, Sun Acquisitions, we always start with these three components. If it looks like the client has a good handle on these three components, then it’s a high likelihood that business is going to have a successful transaction. If one of the three is not in good shape, it lowers the odds of having a successful transaction and may even lower the odds of that business selling at all.
These are important components to pay attention to, and things you can do well in advance. Even if you’re not ready to sell your business, these are things that you can be doing so that you’re maximizing the value of your business. I always like to say, “You have a plan in place, maybe you’re looking to sell in 10, 20, or 30 years from now, but life happens. Some events might force you to have to look at a succession plan or an exit. Why not run your business every day as though you might have to turn it over?”
Your Numbers: Financial Situation
The first component is related to the owner’s financial situation. As it relates to that, what’s most important is understanding what your number is. What do I mean by your number? What number do you need in order to walk away from your business to maintain your lifestyle at whatever level you need it to maintain that? For some people, after they sell a business, their lifestyle is going to go down a bit, so their monthly burn rate comes down. For others might stay the same or maybe even go up because they’re going to travel more, or maybe they’re rolling the proceeds into another business, and it’s going to require some good capital. Understanding what your number is, is critical because you then have the benchmark to work against, to decide whether or not your business is there. If not, we get to the second leg will talk about what we do there.
In addition to understanding what your number is, it’s equally important to have all of your estate plans and tax considerations worked out. In the case of an exit, what would happen with your business? How is your business held? Is it held in this in a trust? What are the tax implications of a potential transfer? How much of that sale are you going to keep in your pocket? This is critically important because sometimes your number can be lower if you can maximize your tax situation.Nobody wants to buy the business and have it run the same way static. Everybody wants to come in and take the business to a new level. Click To Tweet
There are many professionals here to be talking to. I highly advise working with a wealth manager, or a financial planner to help you understand what number it might be that you need from your business in order to walk away. There are plenty of models that they can run for you in different scenarios. They can run conservative scenarios or aggressive scenarios. Running these scenarios helps you understand what that number looks like and benchmarking whether or not your business is even close to that.
The next set of professionals that matter are estate trust planning attorneys, who are making sure that you look at how your business is held. What would happen upon a transfer and whether or not you’ve got the most advantageous tax situation? An estate tax attorney is going to help you work through all of those issues. We’ve had different attorneys on our show that you can refer to who can help you think through that and make sure that you’ve got all those pieces set. If you can’t have this piece done, if your personal financial situation can’t be secured, you got a lot of work to do in number two, which is your business readiness.
Business readiness is a big and meaty topic. I like to talk a lot about the value drivers of a business, and there are many value drivers, probably 8 to 12 value drivers depending on the business. Where is your business in relation to all of those key value drivers? The first one is the financial performance of the business. What has been the historical financial performance of the business? Is it steady? Is it slowly growing? Have you had peaks and valleys? Is it up and down? How is the business performed? Obviously, the steadier the businesses, the higher the value of the business.
It’s important to understand where the businesses and how the business performs on key metrics and key ratios as it relates to industry standards. I’m going to pick an industry. If you’re in the HVAC industry, Heating, Ventilation and Air Conditioning, there are benchmarks for what your cost of sale should be or your labor expenses. Do you understand what those benchmarks are? How does your business compare to those benchmarks? There is a lot of industry report out there that can give you this information. If you can’t get access to that, you can always call us at Sun Acquisitions. We have access to industry reports and benchmarks. We can help you think through that through an analysis.
The next piece of the puzzle is, what are the growth prospects for your business? One, the industry that you’re in, how solid is the industry? What are the future prospects for that industry? Two, if a new owner would take over, what would they do with your business? Where would they take it? How would they grow it? What are you doing to execute against those growth plans? How easy are those growth plans to execute? Does it take a big investment or small investment?
This is important, especially if you’re going to transfer the business to a new owner. One of the key things that a new owner wants to understand is, where is the growth in this business going to come from? Nobody wants to buy the business and have it run the same way static. Everybody wants to come in and take the business to a new level. It’s important that you understand where those push and pull points are and that you can communicate that to a new prospective owner.
One of the next important pillars, value driver is concentrations. The first concentration that we focus on is client concentrations. Do you have any one client that represents more than 20% of your business? If so, that is a potential jeopardy for a new owner and a jeopardy for you. Even if you’re not looking to sell, there’s some jeopardy that if you lose that top client, your business can become immediately unprofitable. You should be doing everything to minimize those concentrations. If your top three clients are 50% or more of your business, the same thing holds true. You should be doing everything you possibly can to minimize those concentrations. It’s critically important.
There are other concentrations, vendor concentrations. Does one vendor represent the lion’s share of the products that you’re selling, or two or three vendors represent the lion’s share of products? You want as much diversity in your business as possible. The more diversity you have, the higher the value, the less risk there is in your business. This is all about risk and reward. The less risk in your business, the higher the value of your business.
The other concentrations are related to employees. Do you have 1, 2 or 3 employees that are critical to your operation that if they left, it would create a meaningful void in your business? If so, like clients and vendors, you should be doing everything possible to mitigate that key employee concentration. Cross-training people, hiring up, doing what you have to create a support team around that key employee so if they were to leave people can easily take over those functions. As soon as 1, 2 or 3 employees become critical to your operation, the risk for you as an owner goes way up. The risk for a potential new owner or acquirer goes way up.
The next category is related to sales and marketing. In all of my years of M&A transactions, this is typically one of the areas that most owners pay little attention to. Building a solid sales and marketing function. In many cases, owners become the pseudo sales force or the lead salesperson. There’s risk in that. A new owner that takes over is going to worry that you have most of the relationships and that creates risk for them. Creating a solid marketing plan where the business generates leads through processes, whatever they are. Whether that’s social media marketing or an inside sales function that does telemarketing phone calls, going to trade shows. However it is that you generate leads, you have a clear marketing plan that is in charge of making sure that your brand is protected, you’ve got goodwill in the community, and that the marketing function is generating leads for your sales organization.
You have a good sales organization, not just one salesperson but hopefully, a couple that knows how to close business and are incented properly to stay with the business and help you grow the business. I can’t stress enough how important sales and marketing is to a new owner coming in. For you, as an existing owner. If you don’t want to sell for twenty years from now, how much stress does that take off of your plate if you’ve got this function well thought out?
In line with sales and marketing is recurring revenue. If you can build recurring revenue into your business, you have now increased the value of your business dramatically. I’m not talking about repeat business. There’s a real difference between repeat business and recurring revenues. I’m going to use the HVAC industry. They’ve done a good job over the last several years in building in-service contracts to their businesses where they have clients sign up for annual renewable contracts and they auto-renew. That automatically gives someone 1, 2 or 3 visits a year, that’s going to happen clockwork. Every year auto-renews, there’s a bill that goes out. That is a good example of a recurring revenue model.The more diversity you have in your business, the higher the value and the less risk there is. Click To Tweet
Even better if you can build something that is recurring revenue on a monthly basis, where you build a subscription model into your business. Anything you can do, even if it’s a small percentage of your overall revenue, to build some base of recurring revenue, increases the value of your business dramatically. Repeat business is not bad. We all love repeat business, but recurring revenue is in a league of its own.
The next thing that people look at is what are the capital requirements to run that business? Simply stated, how much capital needs to be invested in that business month in and month out to generate revenues? The less capital you have to spend every month to generate revenues, the higher the value of your business. You’re running a manufacturing plant, and you’re constantly having to invest in new technology, new machinery. That increases your capital requirements, which increases the risk of your business. Because if there’s a downturn, is that new piece of machinery going to be able to support the debt service that you’ve taken on to bring that new piece of machinery online in the business? The less capital that you have to put into the business, the more cashflow that you have in the business and the higher the value.
Competition is the next value driver to take a look at. How much competition are you up against? How easy is it for competitors to enter your market and start competing with you? Are the barriers to entry high? Are they low? In this regard, do you have a niche that’s going to be hard for somebody to replicate? The easier it is for a competitor to come in and compete against you, the lower the value for your business. If you’re in that situation, you should be thinking about can you create a niche? Can you carve out something in your business that gives you a competitive, sustainable advantage? If not, should you be looking at adding a completely different product or service line that gives you that advantage? Competition and understanding where you fit in the competitive landscape matters.
Customer satisfaction is high on the value driver list. How satisfied are your clients with you? Some of the things that people use as benchmarks are their Google reviews on your business or some reviews that people can easily see. How do you fare in those reviews? If there’s anything you can do to get your business, Google reviews or other types of reviews are important, especially as it relates to social media and search rankings. It helps quite a bit when you can get great social media reviews on the internet. If your business doesn’t lend itself to those sorts of reviews, there are other ways to go figure out if your customers are satisfied. The one that I refer to more often than not is something called the Net Promoter Score, NPS. You can look it up. It’s a simple way. It’s one question that you ask your clients and you can relate their responses. It allows you to mathematically come up with where you sit as far as a Net Promoter Score and a great way to understand what your clients think about you and your firm. It’s a great way to evaluate your business.
The last value driver that I’m going to talk about in this section of business readiness is whether or not your business is a self-managing business. It simply comes down to how much are you involved in the business as the owner? If you are having involved in the business, the value of your business is going to be on the lower end. The more you can turn over to people in your business, the more responsibilities that you can turn over so that you’re spending more of your time on strategy. High-level stuff that isn’t related to day to day operations, you’ve increased the value of your business dramatically. You have probably also increased your level of satisfaction because you are not the person that has to be involved in every aspect of the business. In key aspects, you’ve got the proper processes in place, the proper people in place, checks and balances are clearly important. You want the right checks and balances so you know the business is operating properly. The more you can do that, the higher the value of your business.
The last thing that’s not related to value driver, but the thing that you need to understand is what is the value of your business? Getting a snapshot value of your business every couple of years should be high on your list. There are statistics out there that 90% of an owner’s wealth, in most cases, is tied up in their business. To put it in another way, an owner’s business is typically, if not their largest investment, in their top three. Understanding the value of your business and how a value driver impacts that value up or down, and where that value sits every couple of years is critically important. That feeds into the first part, which is your personal financial readiness. You’re going to need that number in order to be able to talk to your financial advisor about what your business is worth, so they can plug that into whether or not you are ready from a personal perspective.
That leads me to item number three, which is an important topic. Maybe if you are at the point where you’re considering a sale in the next year or two, this becomes critically the most important, which is your emotional readiness. Are you emotionally ready to walk away from the business? This requires some soul searching, asking some tough questions of yourself and being honest in those answers. When we meet clients for the first time and we do an intake with them, one of the key questions I’m going to ask is, “What would you do after the sale of the business.” When owners respond in a vague way or they’re not certain what they’re going to do after the sale of the business, that worries me. I’m concerned because that tells me that maybe they haven’t gotten to the point where they can disconnect from the business.
This is problematic because if you can’t disconnect from the business, but you go forward with a potential sale, you’re going to get through that process halfway through or a quarter of the way through. Maybe even right up to the day of closing and you’re going to feel tremendous remorse. You’re going to have a lot of anxiety. You may even wind up pulling out of the deal, and you would have spent a lot of money and a lot of time when you weren’t ready. Understanding your readiness matters.
The answers that I love to get to the question that I asked clients, the first time we meet them is when they can describe to us a post-sale scenario. I use this example often. An owner who said to me once, “I’ve got a place in Colorado. I can’t wait to get there. I can’t wait to have my grandkids come and visit. I can’t wait to teach them how to horseback ride.” That owner is envisioning the next stage of their life and what they’re going to do next. That’s great because it tells me they’re going to be ready for the ups and downs of a process. They’re going to be realistic. Assuming that we can get decent offers, they’re prepared to move on and they’ve reconciled that for themselves.
I have a dear friend who went through this process. He sold his business. He’s on the younger side and he was completely happy with the financial outcome of the transaction, no issues there. Six months removed from the transaction, he woke up and he realized he didn’t have the next plan for his life. He’s struggling with what’s next. He’s having to figure that out. It always helps when you’ve got plenty of money in the bank and you have time to go figure it out, but it’s an issue nonetheless. It can wreak havoc on your psyche. I heard a statistic at a conference that more than 70% of owners have some remorse about selling and it has nothing to do with the financial outcome. It has more to do with they didn’t know what they were going to do next. It’s created some real angst for them in their life, in their relationships and trying to figure out where to go in all of this.
Those are the three legs of the stool. Are you personally ready? Is your business ready and then are you emotionally ready? Regardless, if you’re looking to sell, you should at least do step number one and step number two all the time, so that you constantly know where you are on that spectrum of being ready if a life event happens, and you have to sell quickly. You can always do the third leg of the stool, emotional readiness, as you’re getting closer to thinking about exiting the business.
In all of this, my high-level advice is to surround yourself with the right advisory team. Get a good wealth manager. Get a good estate and tax attorney. Get a great accountant who understands tax law. Get a good M&A advisor. Get a good business consultant or coach. The right team can help you build a business that’s got maximum value, that is ready at a moment’s notice if you need it to be. Even if it’s not, you’re running at maximum value, so you’re happy, you’re less stressed. It makes for a better situation.
I hope you enjoyed this episode. I hope this information was helpful to you. I’m excited about some of the upcoming interviews that we’ve got coming with people around some of these topics. In fact, sometime in February or early March, we’ve got an episode coming from a gentleman who has built a self-managing business. His story is a great one and he’s in a business that you would never think could be self-managing or could be built into what he’s done with it. It’s a tremendous story. We’ve got some additional guests coming on board that I would have for some great topics. I’m excited about how 2020 is unfolding. I hope you find this information useful. If you need to reach me or contact us for more information, you can get me at DRinaldi@SunAcquisitions.com. I look forward to seeing you again in the next episode. Until then, please remember that scaling, acquiring or selling a business takes time, preparation and the proper knowledge.
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