Saturday, January 12, 2008

To Sell a Business or Not Sell a Business A Crossroads Decision

Thinking of taking your company to the next level with a major capital investment or hiring additional sales resources? These are decisions that can impact your company's future. It might be time to consider the alternative of selling your business.

We are often approached by business owners at a crossroads of taking the company to the next level. The decision in most cases is whether they should bring on the one or two hot shot sales people or channel development people necessary to bring the company sales to a level that will allow the company to reach critical mass. For a smaller company with sales below $5 million this can be a critical decision.
For frame of reference, prior to embarking on my merger and acquisition advisor career, I spent my prior 20 years in various sales capacities in primarily information technology and computer industry related companies from bag carrying salesman to district, regional, to national sales manager and finally Chief Marketing Officer. So when I look at a company, it is from the sales and marketing perspective first and foremost. I am sure that if I had a public accounting background, I would look at my clients through those lenses.
So with that backdrop, let's look at what might be a typical situation. The company is doing $3.5 million in sales, has a good group of loyal customers, produces a nice income for its owner or owners, and has a lot more potential for sales growth in the opinion of the owner. Some light bulb has been lit that suggests that they need to step this up to the next level after relying on word of mouth and the passion and energy of the owner to get to this stage.
I have either spoken with more than 30, primarily technology based companies over the years that have faced this exact situation and can count on one hand the ones that had a successful outcome. The natural inclination is to bite the bullet and bring on that expensive resource and hope your staff can keep up with the big influx of orders. The reality is that in most cases the execution was a very expensive failure. Below are several factors that you should consider when you are at this crossroads:
1. The 80 20 rule of salesmen. You know this one. 80% of sales are produced by 20% of the salespeople. If you are only hiring one or two, the likelihood is that you will not get a top performer.
2. The president of the company and decision maker has no sales background so the odds of him making the right hiring decision are greatly diminished. He will not understand how to properly set milestones, judge progress, evaluate performance objectively, or coach the new hire.
3. To hire a good salesman that can handle a complex sale requires a base salary and a draw for at least 6 months that puts him in a better economic condition than he was in on his last job. So you are probably looking at $150,000 annual run rate for a decent candidate.
4. If you have not had a formalized sales effort before, you are probably lacking the sales infrastructure that your new hire is used to. Proper contact management systems, customer and prospect databases, developed collateral materials and sales presentations, sales cycle timeframes and critical milestones and developed competition feature benefit matrixes will need to be developed.
5. Current customers are most likely the early adapters, risk takers, pioneers, etc. and are not afraid of making the buying decision with a small more risky company. These early adaptors, however, are not viewed as good references for the more conservative majority that needs the security of a big company backing their product selection decision.
6. Your new hire is most likely someone that came from a bigger company in your industry and may be comfortable performing in an established sales department. It is the rare salesman that can transform from that environment to developing the environment while trying to meet a sales quota. Throw on top of that the objection that he has never had to deal with before, the small company risk factor, and the odds of success diminish. Finally, this transformation from a core group of early adapters to now selling to the conservative majority elongates the sales cycle by 25% to as much as double his prior experience. If you don't fire him first, he will probably quit when his draw runs out.
With all this going against the business owner, most of them go ahead and make the hire and then I hear something like this, "Yes, we brought on a sales guy two years ago who said he had all the industry contacts and in nine months after he hadn't sold a thing and cost us a lot of money, we fired him. That really hurt the company and we have just now recovered. We won't do that again."
What are the alternatives? Certainly strategic alliances, channel partnerships, value added resellers are options, but again the success rate for these arrangements are suspect without the sales background in the executive suite. A lower risk approach is to outsource your VP of Sales or Chief Marketing Officer function. There are a number of highly experienced and talented free lancers that you can hire on a consulting basis that can help you establish a sales and marketing infrastructure and guide you through the staffing process. That may be the best way to go.
An option that one of our clients chose when faced with the six points to consider from above was to sell his company. This is a very difficult decision for an entrepreneur who by nature is very optimistic about the future and feels like he can clear any hurdle. This client had no sales background but was a very smart subject matter expert with an outstanding background as a former consultant with a Big 5 accounting firm. He did not make the hiring mistake, but instead went the outsourcing of VP of Sales function as step 1. When their firm wanted to make the transition from the early adapters to the conservative majority, the sales cycle slowed to a crawl. Meanwhile their technology advantage was being eroded by a well funded venture backed competitor that had struck an alliance with a big vendor.
They engaged our firm to find them a buyer, but then we encountered the valuation gap. Our business seller thought his company was worth a great deal and that he should be paid with cash at close for all the future potential his product could deliver. The buyer, on the other hand, wanted to pay based on a trailing twelve months historical perspective and if anything was paid for potential, that would be in the form of an earn out based on post acquisition sales performance.
With a well structured earn out agreement and the right buyer, our client will reach his transaction value goals. His earn out is based on future sales, but his effective sales force has been increased from one (himself) to 27 reps. His install base has been increased from 14 to 800. Every one of the buyers current customers is a candidate for this product. The small company risk has been removed going from a little known start-up with $500 K in revenues to a well known industry player, publicly traded stock with a market cap of $2.5 billion.
He avoided the big cash drain that a bad sales person hiring decision would have created and he sold his company before a competitor dominated the market and made his technology irrelevant and of minimal value.
My professional contacts sometimes tease me and suggest that I think every company should be sold. That may be a slight exaggeration, but in many instances, a company sale is the best route. When a business owner is faced with that crossroads decision of bringing on a significant sales resource that will be faced with a complex sale and the executive suite does not have the sales background, a company sale may be the best outcome.

Dave> Kauppi
is a Merger and Acquisition Advisor and President of MidMarket Capital, representing owners in the sale of privately held businesses. We provide Wall Street style investment banking services to lower mid market companies at a size appropriate fee structure.

Sell a Company - How is the Selling Price Determined?

Bussiness valuations are a valuable tool to set a range of prices when you sell a business. The only true way to determine value, however, is to present the business to the universe of buyers in a true open market bidding process.

How much are you expecting when you sell your business? I always ask this question of our clients. The answers are as different as the businesses. "We need $5 million to give us the type of retirement we want. We have invested $2 million in the product. Our investors have put in $3 million so far. It should sell for $5 million. I heard that XYZ Company got $30 million for their company." Well, my response to my clients doesn't necessarily endear me to them, but it is the truth. The market doesn't care. The market doesn't care how much it cost you to develop the product or how much your investors have in or how much you need to retire or how much you think it is worth.

The market looks at what the ROI is for its investment in a company. If you are fortunate enough to have a technology that can be leveraged, the market may look at the future returns of that technology in stronger hands.

For most businesses, there are benchmarks that are often used as a starting point. The most common in a merger and acquisition situation is an EBITDA multiple. That is the gold standard for privately held companies, similar to what a PE multiple is as a business valuation metric for publicly traded stocks. One of the measures that has come into vogue on Wall Street is a PEG multiple or Price Earnings Growth. It is essentially a way to attempt to quantify the difference in PE multiples between two firms in the same industry that have a much different future growth scenario.

A very interesting discovery that we have made in engagements to sell a company that is privately held is that buyers attempt to ignore this factor when making their purchase offers.
We recently represented a company in an M and A deal that was in an industry characterized by slow growth of about 4%, had commodity type products and consequently very thin gross margins, and had little pricing power. Our client introduced a new product that was unique, had very healthy margins, retained some pricing power, and was experiencing 50% year over year growth.

The industry benchmark valuations were at 4.5 X EBITDA. We had the three largest players in the industry all interested in the acquisition and each one put out an initial bid that was, surprise, about 4.5 X EBITDA. Another factor was that our client was in rapid growth mode so a good deal of their costs were front end loaded as they launched a few big box retailers during this period. The effect of this was to depress their EBITDA performance. This made these offers even more inadequate.

The result is that we have a classic valuation gap between business buyer and business seller. This is the biggest reason that many merger and acquisition transactions do not happen. Our clients are terribly disappointed and suggest that these buyers "just don't get it." Our buyers have experience in making several acquisitions in their space and have their business valuation metrics pretty much in stone and think our sellers are being unreasonable in their expectations. Game over, right?

Not so fast. One of the most important roles of a business broker, merger and acquisition advisor or investment banker is devise a transaction value and structure that works for both parties. We go to the buyers and point out that their traditional way of looking at these transactions is appropriate for their prior acquisitions with standard growth metrics, lack of pricing power, and commodity type products. We go to our business sellers and point out that as a small company with a few big box retailers comprising 80% of company sales with essentially one main product, that they have a great deal of small company risk. For example, if the retail buyer from XYZ Big Box Retailer changes and is replaced by a buyer that has a consolidation of vendors bias, then they could lose 30% of their business with one decision. A bigger company, however, with 30 SKU's would be much harder to replace with a change in buyers.

We have established a platform with both buyer and seller to consider alternatives to their hard and fast valuation positions. Here is an example of a business sale transaction structure that could be a win for both buyer and seller:

1. $1,000,000 Cash at Close which is approximately a 4 X EBITDA multiple for the year 2007.

2. An Earn out (Additional Transaction Value) based on SELLER COMPANY'S Sales Revenue beginning in year 1 and ending at the end of year 5. The earnout is at risk, but is set to net the shareholders a 6 X EBITDA multiple on 2008 projected sales (sales $6 million and EBITDA margin of 16.67% or EBITDA of $1,000,000).

This is the transaction structure we are recommending to balance a low EBITDA valuation on a company that will grow revenues by 50% next year. If they don't, then the earn out will be less. Most of the transaction value is in future performance based earn out. Our projection is that with BUYER COMPANY cost efficiencies, BUYER COMPANY can improve operating performance by an amount that covers the entire earn out amount and maintains or even improves SELLER COMPANY'S historical margins.

Most business buyers that approach a company with an unsolicited interest in acquiring them are bottom feeders and will attempt to buy way below the market. They will attempt to draw out the process and pursue several acquisitions simultaneously hoping that one or two sellers just cave and sell out at a discount. They may start out at a decent valuation, but as they go through their due diligence process will find one issue after another that makes them reduce their offer. They often throw out the term "material adverse change" in an attempt to justify their value reducing behaviors. Some business development directors get judged or paid bonuses on how much below the original offer they can ultimately close the deal.

What is the way to combat this bad buyer behavior? The best way is to have options. Those options are multiple interested buyers. We feel very uncomfortable when we are engaged to sell a company that is difficult to sell. We have taken them through the entire marketing phase and end up with only one legitimate interested buyer. You bet that buyer recognizes the issues and the likelihood of limited interest and will attempt all of the maneuvers to drive down the buying price and terms. Our negotiating position on behalf of our seller client is severely weakened and we struggle to preserve value in spite of doing this every day. Think about how effective you will be in this single buyer scenario. We tell our prospective clients that contact us after an unsolicited offer, "When it comes to business valuation, if you have only one buyer, he is right."

Dave> Kauppi
is the editor of The Exit Strategist Newsletter, a Merger and Acquisition Advisor and President of MidMarket Capital, representing owners in the sale of privately held businesses. We provide Wall Street style investment banking services to lower mid market companies at a size appropriate fee structure.