Part One: Five Considerations for Business Owners
In this article series, Harris Williams Managing Director Bill Watkins, the firm’s specialist in advising family-owned businesses, shares his insights on preparing to sell your business.
This initial article covers the five key issues that have the potential to disrupt a transaction, and how to address them. Subsequent articles will include a comprehensive exit preparation checklist, as well as detailed guidance on due diligence.
Preparing for a sale is important, even if you don’t intend to sell.
Whether the need to sell is caused by a family issue, a change in the industry or an economic event, it can arise unexpectedly. Preparing for that need may not have been a priority for you yet. If you are like many entrepreneurs, you’ve been busy building and growing a thriving enterprise, and you have not been dedicating as much time to the idea of selling it. In fact, it may be your intention to keep your business in your family forever.
Even if that’s the case, you still need an exit strategy. Similar to having the insurance you need, maintaining an up-to-date exit strategy is an essential business practice. Simply put, it’s what your business deserves. Without a well-conceived exit strategy, you likely won’t be able to obtain the full price your business and its future prospects should command.
In essence, an exit strategy is another form of succession plan. Just as you have thought about who can fill your shoes when you are done leading your business, you should spend some time thinking about who the next generation of owners could be, if not your family. The right owners could even take your business to the next level with fresh infusions of capital, technology and talent.
How will you attract those people, convince them of your firm’s long-term value, and manage the many complex negotiations and agreements involved in a change of ownership? And how will you do that while still running your company? What if all of this happens in the midst of an unforeseen, challenging event?
“Ultimately, your preparation level is one of the few things over which you have some control,” says Watkins. “You can’t control the markets, your industry, or even what the next generation is going to want to do with their careers and lives. But you can control how well prepared you are to realize the full value of your business.”
Five “Battleground” Topics
There are certain topics that are considered critical, and that can be areas of contention with potential buyers when going through a transaction. We’ve coined these “battleground” topics. To be clear, says Watkins, most transactions in which Harris Williams has been involved have been more like dances than battles. Yet he believes the reason for that is careful preparation for potential battleground issues.
“That means thinking like a buyer, and proactively identifying and managing potential concerns,” he explains. “It means hitting your targets, being able to quantify your growth story, and being organized in terms of data and financial reports. And it means assembling a team of professionals to help you through the process.”
Most importantly, says Watkins, the key principle of achieving a smooth and successful sale is thinking through five key areas, and having the data you need to answer tough questions: “We see these issues come up fairly consistently, and you can prepare for each of them.”
Strong, steady, predictable growth is the key reason buyers or investors will be interested in your business, Watkins says. Yet demonstrating past growth is merely table stakes. Buyers are looking for evidence that their investment in your business will grow substantially going forward. As such, says Watkins, be prepared to explain where future growth will come from, what could limit it, and how the business has been optimized for that potential.
Buyers will ask where your business is in terms of its evolution and maturity, and how much growth potential remains. They will want to know if growth will require additional investment, and what the payback will be. They will likely ask about competitive threats, both from within your industry and adjacent to it.
Watkins uses the example of the music industry: “The Walkman was cool in 1980—a true disruptor in the industry. Few people at the time predicted the speed of technological advancement that quickly created dinosaurs within the music distribution and delivery model. Those that did clearly came out ahead.”
A closely related topic is the specific industry in which your business operates. Size is one key factor: Strong growth in a small market is arguably less valuable than moderate growth in a larger market. Either way, it is essential to clearly define your addressable market opportunity, providing prospective buyers with a detailed picture of your business’s remaining runway for growth.
Also think beyond the traditional boundaries of your industry. Could your company tap into unmet demand in other industries with modest investment? As an example, software companies that specialize in industry-specific platforms may be able to readily adapt their products to other industries.
Conversely, how vulnerable is your business to unconventional competitors from adjacent spaces? What factors provide protection against such interlopers? What can you do to further protect your position?
“It’s critical to look at your business and its potential white space,” says Watkins. “How could a new owner turn it into four to five times what it is today? At the same time, you need to make sure you have data, case studies, and all the other facts you need to illustrate to buyers that those scenarios are possible, and not just ‘pie in the sky.’”
Many businesses have a finite lifetime, linked to larger demographic, social or technological trends. The Walkman case above is just one example of a business model or product rendered obsolete in a short period of time.
Overall, Watkins says, “The value proposition for your customers can be an overused cliché, but your ability to craft the story and illustrate the value you provide in the course of sale preparation is immeasurable.”
Watkins suggests asking yourself tough questions about your business: Is this a business model that has long-term relevance? Should your business still be here? If it goes away, will anyone care? How defensible is it? How easily could it be disrupted? What are the risks to the business from disintermediation (e.g., “the Amazon effect”)?
In particular, customer, product and geographic diversity (or lack thereof) are major diligence items for potential buyers and investors. Too much customer concentration—particularly with major players like Amazon or Walmart—can be a red flag, and must be addressed. The same can be true for suppliers and end markets. Take a critical look at any areas of your business that may be too concentrated, and proactively diversify them.
Watkins also suggests you ask yourself if your business could be a disruptor in its industry: “Think through the trends you could play off of with your current business model. Are there underserved segments to address or old-fashioned competitors to replace? Could you build disruptive capabilities on your own, or would you need to do it by acquiring another business? Do you have the management team in place to take advantage of these opportunities?”
Growth, markets and business models only matter in the context of strong, steady financial performance, says Watkins. In particular, he advises, potential buyers will want to know the historical quality of your business’s financial performance.
Is it a “choppy” business with major periodic capital expenditures that drain cash flow? How stable are your margins? Is your financial performance tied to commodities such as metals or oil? Buyers will also want to understand how easily you can pass along such variability to customers, and how severely it affects margins.
“Add-backs” are another key battleground issue. These should truly be expenses new buyers will be unlikely to face during their ownership: one-time charges, personal expenses, etc. “You need to get very comfortable and rational with what you’re adding back to EBITDA,” says Watkins. “Buyers will expect clear explanations for all of them.”
Potential buyers and investors will also want to understand the relationship between your business’s free cash flow and its working capital. Free cash flow is defined as the cash your company generates through its operations minus your operating expenses and capital expenditures. Working capital is the difference between your company’s current assets—including cash, accounts receivable and inventory—and its current liabilities, such as accounts payable.
Generally speaking, buyers will be looking for well-controlled working capital and substantial, steady free cash flow. To achieve this, consider how much room you have to shrink accounts receivable and stretch accounts payable. By how much could you reduce inventory without affecting operations? Anything you can do to reduce and control working capital will help bolster your free cash flow.
This raises another key consideration, notes Watkins: “You might find you have a gap in personnel and need additional help establishing the quality of your earnings and updating all of your financials on a monthly basis throughout the sale process. You don’t want to be scrambling to deliver data to buyers or investors during negotiations. And you need to be critical in your self-assessment—there may be negative adjustments to earnings relevant to the business.”
How your business operates within its respective regulatory environment is also a common issue for prospective buyers and investors, says Watkins. Regulations can encompass a wide range of operational considerations, including environmental impacts, human resources, safety and insurance. Being out of compliance in any of these core areas will be a major complication to your exit strategy.
Taxes also are a factor within the regulatory framework. Business owners need to address their respective personal tax situation and estate planning in the construct of an exit strategy. “Absence of a thoughtful tax and estate plan can destroy economic value to the family and shareholders, regardless of the preparedness of the business and strength in the capital markets,” says Watkins.
Overall, regulatory factors can be positive or negative. When your company provides a product or service that is required by law or regulation, it can foster recurring revenue, strong margins and “sticky” customer relationships. Conversely, some businesses are dependent upon government reimbursement, which can add complications, erode margins and limit growth.
“Whether it’s a pro or con or a combination, make sure you are able to document the concrete impacts on your business of relevant regulations,” says Watkins.
Preparation is the key to realizing the full value of your business. It’s much better to be proactive regarding potential issues and craft a compelling narrative about them than to be fielding tough, unanticipated questions, says Watkins.
And that preparation is valuable whether or not you intend to sell your business. A number of unexpected factors could require you to find a new owner, from shifts in the industry to more personal issues. In Watkins’ experience, many businesses meet with a team of advisors periodically to review and update their sale preparations, adjust the value of their business and reconsider their potential battleground topics. Such teams typically include an attorney, an accountant and an M&A advisor.
“That helps create that cohesive, convincing story about your business,” he explains, “which is what can set it apart from other similar companies. Almost any business can be sold, but only a few are sold for their full potential value. Early, careful preparation is one of the keys to generating a successful result.”
Next article: The Complete Sale Preparation Checklist
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