Mark S. Campbell, CPA, ABV, CFF, JD
Partner

By most accounts, there is a wave of small- and medium-sized businesses that will be sold in the next five to ten years.  Studies have shown that of the 78 million members of the baby boomer generation, nearly 10%  are small business owners.  In addition, nearly two-thirds of business owners in the United States do not have children that plan on taking over the family business.  This leaves an estimated five to seven million small businesses without a family succession plan.  In all likelihood, these businesses will come to market in one of three ways: 1) the owner will leave the business to his or her estate who will either sell or dissolve the company, 2) the owner will become an absentee owner or dissolve the company and retire (leaving market share to be taken by another entity), or 3) the company will be sold to employees or a third party.  Of the three scenarios, maximum value to the owner is typically achieved only by a sale to a third party. 

The big question is… what will the business be worth and how can an owner maximize the value?  For a variety of reasons, most small businesses are typically valued based on the cash flows they generate.  The basic formula used in valuing the cash flows of a business is comprised of two parts: (1) the numerator consists of the normalized cash flow of the business, and (2) the denominator consists of a discount rate.  The discount rate can really be thought of as the risk associated with generating the normalized cash flows of the business.  The more risk associated with the cash flows, the higher the discount rate will be, thus resulting in a lower value for the business.  Many systematic risks cannot be controlled by the business owner.  However, there are many unsystematic or company specific risks (some real and some perceived) that a business owner can control, or at least minimize.  This article will discuss three areas small- and medium-sized business owners should consider to increase value from a sale of their business: value drivers, operational due diligence and financial reporting.

 Value Drivers

Very often a business owner is focused on growing the top-line revenue of his or her business.  This is obviously an important driver of value.  However, if the risk associated with cash flow is still high, the incremental value being generated by revenue growth will not be maximized.  Taking steps to reduce the company specific risks can generate as much or more value for the business owner.  Two common risk areas for small businesses are lack of management depth (“key man” risk) and customer or supplier concentration.

Management Depth

The number one value driver for companies is the management team.  For many closely held businesses, this management team consists of only a few people, or even just one person.  To build a valuable business, the management of the organization should include people with a variety of skills who can successfully run the business after the owner’s departure, and, collectively, do much of what the owner does today.  Developing a strong management team helps in two ways.  It can increase value to a third-party buyer who will require much of that management team to continue in operations after the owner departs.  It may also provide for an alternate exit strategy.  If the management team is strong, it may have an interest in working with the business owner to structure a management buyout plan.

Customer/Supplier Concentration

A second way to increase value is to reduce customer or supplier concentration.  There is an increased risk to the business when a single or small group of customers or suppliers make up a significant portion of sales or supply chain, respectively.  Should the business lose that major customer or if a major supplier suffers some kind of business disruption (i.e., a natural disaster), there is increased risk of an adverse impact on the company. There can be ways to try to reduce concentration risk, but it is often easier said than done.  As mentioned above, since there are many other similarly situated companies, a merger with a business operating in the same industry (i.e., a competitor) may potentially diversify the customer base.  Very often, one plus one can equal more than two by reducing risk and increasing cash flows.

As can be seen in the sensitivity analysis below, decreasing the discount rate can have as much or more impact on value as increasing the growth rate.

 

 

In addition, growing revenue does not necessarily generate greater value if margins do not result in greater net free cash flow.  As seen in this second sensitivity analysis, increasing margin can have a similarly large impact on value.

 

The next two areas may seem to be related more to perception than financial risk during the sale process, but they can be of equal importance.  They are the operational due diligence and financial reporting capabilities of the business.

Operational Due Diligence

Any sale to a third-party buyer will almost certainly include a due diligence period where the buyer has a chance to “kick the tires” and see if there are areas that may reduce the agreed-upon estimated purchase price and/or provide an indication of greater post-merger value.  Operational due diligence is crucial and can have a significant impact on the deal structure and price.  Some of the areas to consider are:

  • Systems and procedures for each functional area are documented, including training, human resource issues, worker’s compensation claims, etc.
  • All important operating documents are up-to-date and include evidence they were executed properly.
  • Intercompany and related party transactions are well documented and treated as arm’s length.
  • All contracts, especially those with significant customers or suppliers, are currently in effect and executed properly including terms stated on purchase orders, master service agreements, etc.
  • All federal, state and employment tax liabilities and payments are current.
  • Insurance policies are adequate and current.
  • Real estate owned by the business has all title documents and deeds.
  • The business “shows well” and offices, warehouses and manufacturing facilities are organized and properly maintained.
  • Repairs and preventative maintenance on all machinery and equipment are documented and conducted in accordance with specifications.
  • Transferability of intellectual property by the business.
  • Any “handshake” deals with customers or suppliers and whether it is possible to memorialize those agreements in a signed contract.

Documenting and organizing a “data room” of all significant information that a third-party buyer might want to see is often a good way of uncovering areas that may have lapsed or otherwise have been neglected.

Financial Reporting

One of the most important capabilities of a business is having the ability to extract timely and relevant information from its information systems.  Third-party buyers, especially financial buyers, will often ask for financial information that may not have been historically prepared by a business.  Having the flexibility in the financial reporting system to be able to extract information in various ways is invaluable to this process.

During the presentation to a potential buyer, it is often an expectation that management provide accurate answers to questions about the current state of the business’ financial position, rather than rough estimates or a “gut feel”.  A more precise response gives comfort to the buyer and adds more value to the negotiation process.  Even being in a position to positively state that the information is readily available goes a long way toward establishing comfort with a company’s financial capabilities.

Even with smaller businesses, there are customizable and inexpensive software applications that enable owners to extract more relevant financial information than what might typically be available from standard financial reporting packages.  Focusing efforts and resources in the appropriate areas can greatly enhance value to the small- and medium-sized business.

Further, having ready access to non-financial data can be equally important.  Businesses that track metrics specific to their industry can have an impact on value.  Examples include days on hand of inventory, defects per thousand, backlog to sales ratio, bill of material accuracy, etc.  These highlight areas in the business that are either under- or over-performing relative to others in the industry and can provide a good indication of the overall health and maturity of the organization.

Finally, having audited or reviewed financial statements lends a level of comfort to the financial information provided, which can potentially add to the value of the business or may eliminate GAAP-related post-closing adjustments.

While this article covers some of the basics for business owners, it is often best to work with experts in this area to help you prepare for the transaction, maximize value and help ensure smooth post-transaction integration.  Doing so can enable the business owner to continue to focus on business operations. 

Mark S. Campbell, CPA/ABV/CFF, JD, is a manager with BlumShapiro, the largest regional accounting, tax and business consulting firm based in New England, with offices in Connecticut and Massachusetts.  The firm, with nearly 300 professionals and staff, offers a diversity of services which includes auditing, accounting, tax and business advisory services.  In addition, BlumShapiro provides a variety of specialized consulting services such as succession and estate planning, pre-transaction due diligence, business technology services, employee benefit plans, litigation support and valuation, and financial staffing.  The firm, with offices in West Hartford and Shelton, CT and Boston and Rockland, MA, serves a wide range of privately held companies, government and non-profit organizations and provides non-audit services for publicly traded companies.

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