Improve the Value of Your Business and Sell It Faster
News, Morgan & Westfield – August 2015
Corporate / Transaction Advisory
In Morgan & Westfield's Deal Talk, Garrett Wilson explains earnouts, working capital adjustments and normalized salary.
Today it is our pleasure to interview Mr. Garrett Wilson, a Senior Manager in the Denver office of RGL Forensics. Mr. Wilson specializes in the field of business and security valuation and his work includes financial, economic and valuation analyses for financial reporting purposes, mergers & acquisitions, asset and securities valuations, manager selection, corporate strategy and litigation. Mr. Wilson explains earnouts, working capital adjustments and normalized salary. He goes on to give factors that can improve the value of your business and discusses how long it can take to sell your business. Those are just a few of the topics discussed in today’s interview!
Tina: What are the most important factors that improve the value of a business?
Garrett: Effective management depth, attractive returns on invested capital and an optimized capital structure are key factors that can improve the value of any business. Potential buyers recognize that management depth greatly affects the vision, growth, stability and longevity of an enterprise. Additionally, buyers will often reward businesses within attractive industries that harness key differentiators from competitors with higher valuations due to their superior long-term returns on invested capital. Lastly, trusted advisors can assist management in unlocking tremendous business value through the strategic process—either in isolation or as part of the M&A process—of optimizing the capital structure. Ultimately, any business that proactively incorporates these three factors into its culture can significantly improve its value in the marketplace.
Tina: On average, how long can I expect for it to take to sell my business? Is there anything I can do to speed up the process? Any shortcuts I can take?
Garrett: If the goal is to maximize price—as it usually is—the sale process can sometimes take substantially longer than a business owner might expect. The sale process frequently requires six to nine months from the time an owner is fully prepared to sell his or her business to the ultimate closing of the deal, including buyer outreach efforts, the fielding of indications of interest, due diligence, the negotiation of final terms and documentation, and any pre- and post-closing adjustments. Although these specific steps are considered by many to be the sale process, they really constitute just the tip of the iceberg. In fact, an essential part of any deal is the preparation phase, which can take several months or longer and can have a material impact on the length of the sale process and outcome of the deal. Being thorough during the preparation phase—including engaging trusted advisors early in the process—can dramatically speed up the entire sales process and improve the outcome. This preparation phase involves simulating the due diligence that a potential buyer will ask of your business, including gathering critical and accurate financial, human resources, marketing, customer, supplier, environmental, regulatory and legal information. Ultimately, the only effective shortcut for a sales process is to plan far ahead for your desired liquidity timeline and work towards that goal with the aid of your trusted advisors by proactively implementing the best practices of a much larger organization into your business.
Tina: I am preparing to sell my business. Do you feel it is necessary for every business to receive a formal business appraisal prior to being listed for sale? Would there be a time a business appraisal would not be necessary?
Garrett: While a formal business appraisal may be beneficial in many ways, not every business needs to pay for one prior to going to market. In the absence of a formal appraisal, however, you may risk being misinformed about the value that your business can achieve in a sale. Formal appraisal or not, it is essential that you have reasonable expectations for the range of values your business may achieve in the marketplace, along with an understanding of the key drivers of that value range. By understanding this before formally placing your business for sale, you help to ensure that you are not diverting your valuable time and effort towards a sale process that has little to no chance of achieving the outcome you desire. Ultimately, the capital market sets the value for your business so having timely and relevant information about that market is key to making the right decision for you and your business. This usually involves the help of an appraiser and/or a trusted advisor.
Tina: The buyer submitted an offer contingent on bank financing. Is he going to need a business appraisal? Will I be required to provide financing if the bank does not give financing?
Garrett: No, a bank does not typically require an appraisal. The bank providing the financing is primarily interested in the collateral and/or cash flow of the business—saleable assets available should the borrower default on the loan. In some situations, the bank may request an appraisal, but it is the exception and not the rule. If the bank does not approve the financing, the seller is not required to provide financing unless it has already been formally agreed to in a definitive executed document. Ultimately, the seller is not required to sell the business to that buyer. So, at that point a decision must be made to either proceed with seller financing for that buyer, with an understanding of the inherent risks involved, or to move on to other potential buyers. If a seller provides financing, he or she should perform serious due diligence regarding the counterparty and performance risk of receiving future payments under the deal terms. The seller will need to decide if he or she is willing to sell the business for the down payment and risk receiving nothing else in the future under a worst case scenario. While seller financing is normal in some industries, there is always a substantial risk.
Tina: What is considered a normalized salary and how is it relevant in determining business value?
Garrett: A normalized salary is the economic value of somebody’s time. This is determined by looking at what base salary, bonuses and benefits the employee (owner or otherwise) would earn for the time contributed in an arms-length open market. The arms-length nature of normalized compensation is key to understand, since many owners do not always take one but rather receive some combination of salary and distribution of profits. In determining the value of a business, the buyer will look at normalized cash flow—what the future cash flow of the company will be with normalized compensation for all employees including any owners who are active in the business. If the seller is taking more than the normalized compensation, they have effectively lowered the reported cash flows of the business that would be available to the buyer. If the owner takes lower compensation salary opting instead for profit distributions, he or she has indirectly inflated the reported cash flow that is available to the buyer. These numbers need to be adjusted to normalized numbers so the buyer understands the amount of future cash flows that they are purchasing.
Tina: Should I sell my business to a foreign acquirer? What are the risks/benefits, if any?
Garrett: There is no reason to constrain your pool of potential buyers. When selecting a buyer, it is important to clearly examine the risks and benefits of the sale to you and your organization. If the foreign acquirer is the best potential buyer for your business, then sell to that person or entity. For example, the purchase of an existing US business can be an easy way for a foreign acquirer to enter the market and they will often pay more for the opportunity than a domestic buyer might. Some of the risks of selling to a foreign acquirer may include more complicated litigation in a deal dispute or cultural issues during integration. For some businesses and industries there may also be governmental regulation issues that may impede, prevent or delay a sale to a foreign acquirer.
Tina: What is an angel investor and should I sell my business to an angel investor? Are there risks/benefits to doing this?
Garrett: Different from venture capital or private equity investors, an angel investor is an individual who personally believes in the business idea and is willing to provide funding for a high return on their investment. They are generally an investor, not a buyer, and get involved early in your business development to see exponential returns later. There are four main types of funding for a new company: the initial investment comes from your personal funds as the owner or founder; the next level is often money from friends and family who believe in you; then come the angel investors who see potential in the “idea” of your business and provide money to help develop the business; and after that comes venture capital—funding often to expand the business. The availability of angel investors varies with the status of the company. The benefits include the fact that angel investors help build, sustain and grow your company, without needing full control of the business. As with any partnership, the risks are that you dilute your ownership too soon or disagreements with your angel partners arise.
Tina: What is an earnout and how can I structure an earnout to make sure I am paid?
Garrett: An earnout represents additional money paid to the seller based on the business’ future profits. It is designed to incentivize the seller to continue operating the business and remain engaged in the required management transition process in exchange for a higher total sales price. An earnout agreement can help bridge any divide in the opinion of the business’ value between the seller and buyer, by lowering the buyer’s risk and increasing the seller’s total net proceeds. One key to remember is that an earnout is never guaranteed. As such, it is essential that the earnout agreement be specific, concrete and measurable while containing predetermined dispute resolutions that may involve an independent consultant or mediator. Although more variables in the equation can help the buyer and seller get a deal done, they can also lead to more disagreement, more chance of litigation and more chance of not getting paid.
Tina: What is a Working Capital Adjustment? As a buyer, how will this affect the price of the business?
Garrett: Working capital is the amount of money that is necessary to operate the company effectively. These funds allow businesses to pay for normal ongoing costs when they are incurred while they are waiting to receive ongoing revenues. A discussion of working capital in the context of a sale centers on three key numbers: baseline working capital, actual working capital and a working capital adjustment. When selling a business, you negotiate based on a snapshot of the company at a particular moment in time. This is the baseline—values assessed at a given time. When the sale closes later, the actual amount of working capital at the close is measured and may vary from the baseline working capital recorded. Part of the closing negotiations and settlement is to calculate the Working Capital Adjustment—the difference between the baseline and actual. The Working Capital Adjustment is then reflected as an increase or decrease in the final sales price. For example, if the baseline working capital was judged to be $5 million but was actually $6 million on the date sale the sale closed, the purchase price will increase by $1 million. If the actual was $4 million, the purchase price will decrease by $1 million.
Tina: How involved should my attorney be in the process of having my business appraised? Is it necessary to let them know I am appraising my business?
Garrett: The question is not necessarily should your attorney be involved, but who is your trusted advisor? There are a number of advisors who will be involved in the sale of a business – each with their own role. For example, you will likely need a corporate attorney to help prepare the company for sale, a transactional attorney to negotiate and contract the sale, a CPA to maintain and prepare the company’s books, a financial advisor or investment banker to coordinate the sale, and a few other advisors along the way. One of these advisors will be the central focus of the process and negotiations, including the potential valuation of the company. But at the end of the day, you need your financial advisor or investment banker involved in the business appraisal process, not your attorney.
Tina: Do you have any other tips or advice for anyone buying, selling or appraising a business?
Garrett: There are a few tips I would share with those involved in buying or selling a business:
- The rewards are the greatest for those that start their own business rather than buying someone else’s. By starting your own company, you take on all of the risk, but you can also reap much higher returns.
- If you buy a company, your returns will be enhanced if you find a way to add value to that business to increase long-term profitability. Otherwise you are simply buying a job.
- Do not chase trends. Certain types of businesses have become very popular lately but if you are opening when the business is already trendy, you are often getting in at the wrong time when costs are high and competition is fierce. You want to be ahead of the trend—first movers typically reap the most rewards.
- Do your due diligence! Know what you are buying and know what the value drivers and risks are.
- Be reasonable on value, be prepared when you are ready to sell and have the right advisors in place.
Appraisals are based on professional judgment. Find a reputable, objective appraiser or financial advisor that you can trust.
As appeared on Morgan & Westfield Deal Talk, August 2015.