By: Mark Gaeto – Managing Partner
Why do business owners sell their business – their life’s work – and should they? In our conversations with business owners we spend a lot of time trying to understand their motivations to sell, and what they expect as a result of selling their company. There are many reasons for an exit and the chief ones we see are:
- Some owners want to retire
- Some want to hand the business over to their management teams or family members
- Others want to sell their current business and start something new
- Buyers – financial buyers and strategic buyers – start calling
- A partner wants to sell their interest
- Investors come to an end of their holding period and want to have a liquidity event
- The firm is facing troubled times or growth opportunities and they need help and/or capital in order to get to the next level or phase of the company’s development
- New trends such as technology, e.g., the Internet, has significantly impacted marketing and sales, and the management is unwilling to make the necessary changes to be competitive
- The owner recognizes that they’ve taken the firm as far as they can and need to exit so the firm can best transition to the next phase of maturity.
Once we understand an owner’s motivation and expectations we begin to evaluate the urgency of the matter. Should an owner sell now or wait?—and sometimes the right answer is to wait. If waiting is the right thing to do, the next question is, how long?
Why would a banker tell an owner not to sell, at least not in the short run? Often the case is that the owner is exceptionally busy with running their business, and while they are addressing the myriad tactical and strategic issues that come across their desks and smartphones, they often forget or are unaware of an array of company issues that need to be addressed and of the items that buyers will quickly request and analyze. I break down these things and buyer requests into 3 buckets: financial, legal/regulatory, and operational.
One of the first areas one needs to review is the financial and accounting areas. We want to understand how well organized and how granular are a firm’s financial accounts, what the accounting methods are, and whether there are enough accounting controls. Many private/closely held firms do not keep their accounting records in accordance with Generally Accepted Accounting Principles (GAAP). The most common deviation from GAAP is using the cash basis of accounting. It is not uncommon for private business owners to manage their accounting more on a cash/tax accounting basis rather than an accrual/financial accounting basis. The difference between cash and accrual accounting is often very straightforward, with most differences related to timing on revenue recognition and expense payments. While the cash method gives you a clear view of cash on hand and what events have already taken place, it doesn’t provide good or actionable insights on how the company is or will perform in the future.
Since most of the strategic and financial acquirers will maintain the accounting records on an accrual basis of accounting post transaction, we often recommend having an external firm do a cash-to-accrual conversion of the financial statements. In addition to changing the basis of accounting we also recommend a close analysis of payroll and state sales-and-use taxes. On the revenue side it is important to analyze revenue by customer so we can determine stability and diversification of the revenue base.
Next, we look into the legal and regulatory areas. Many times a company’s legal status, the ownership of its intellectual property and a host of other material contracts need to be reviewed. We usually suggest that an attorney do a legal-contract review of the firm. We do this for several reasons. A primary one is around the ownership of intellectual property. We want to ensure that there is a direct, documented and full claim of IP ownership. Next we review operating agreements and buy/sell agreements and any other agreements that could be in place between owners, investors, lenders, and key employees. We also want to know if the basics are covered around legal status and authorization to do business. For example, has the firm filed properly in the states or countries where they conduct business. We review customer contracts to determine revenue recognition and stickiness. We want to see employee contracts and agreements around non-competes, compensation plans, confidentiality. We want to make certain that the employer’s exclusive right in employee-created IP (including inventions and improvements to existing products) is protected. There are a host of human-resources rules and regulations that also need investigation. Lastly, we want to see vendor contracts or any other material contracts such as leases, outsourcing agreements, etc. As more firms use third-party services and software, we need to ensure the company is in compliance and determine if there are any risks.
As former business operators ourselves, we perform an operational assessment to see if the firm can execute at a higher level. What is its growth strategy and potential? How does the firm compete? How are its products and solutions unique and different? Why do customers care, and care enough to buy, and why buy from them over competitors? What is the company vision and related messaging to the market and employees? No doubt it is a business owner’s vision that drives a company’s operation and growth efforts. Plans, budgets, assignments and action are what enable this vision. Hopefully we find that these internal efforts are integrated under one overall program or corporate strategy that the business owner and/or CEO oversees in order to achieve their vision. Many times a formal business plan or core strategic vison document isn’t fully in place and we’ll work with management to produce one. By doing so, the owner can create a lot of confidence with buyers and this can translate to higher valuations and better terms.
Should an owner sell or not and when? Our view is that only after attending to the above can one answer that question. Our belief is that an owner should be doing the above as an ordinary course of business. When an owner has done the right preparation and can show (and articulate) that the firm has the required core operating components and a team that consistently delivers revenue and margin growth, she or he will achieve higher exit outcomes.
Mark Gaeto is a Managing Director with Falcon Capital Partners, a leading mergers and acquisitions firm, where he directs their commercial technology practice.
Mark can be reached at 610-989-8903 or firstname.lastname@example.org