I’m Buying Your Future, Not Your Past

We all know the old cliché, don’t judge a book by its cover.  The analogy in business is, don’t judge a business solely by its financials.  When exploring the acquisition of your business, buyers will inevitably ask the question, “Sure, business is doing great now, but what will impact the future profitability of the business once I’m the owner?”  There are many variables that contribute to revenue generation and cost structure of the business.  The purpose of this article is to explore how negative characteristics of these variables can hurt your valuation.   

This reality is unfortunate - the financial performance of a business will help establish a maximum value, not a minimum.  Issues like the ones below can cause discounts or changes to the deal structure in order to compensate for the risk that they pose.

Concentration of Revenue: When I refer to customer concentration, I am generally referring to one customer generating over 10% of revenue.  In lower market businesses this issue is magnified because of operating leverage; When revenue declines by 10%, cash flow declines by a much higher percentage.   The concern of course to a buyer is that this client could go away immediately after purchasing the business and it would have a material impact on their ability to pay back debt, overhead, or pay themselves.

Concentration of Vendors:  Concentration of vendors can have a similarly debilitating problem to a business owner, but is often overlooked.  In many instances, businesses want to purchase from one vendor in order to achieve volume discounts.  But what happens when your key vendor goes out of business, or the government issues a tariffs on imports from the country where your primary vendor is located? The risk of your cost of goods sold increasing is higher.  Perhaps more debilitating is that terms offered by vendors could suffer and you are required to pay for product upfront until credit is established, rather than receiving 45 day terms. 

Owner is the rainmaker: When I refer to the owner as the rainmaker, I am referring to their role as primary salesperson, relationships with customers, or special skills in consulting, design, or manufacturing.  How will the business perform when the owner is no longer involved? Will new business decline due to the loss of the primary salesperson or key accounts decide to move elsewhere because the owner is no longer available? Maybe the owner works 80 hours/week and the loss of his/her time contribution and key skill sets require additional hiring that will eat into future cash flow.

Key employees: Similar to the owner’s role importance within the business, are there employees who are key to success? Are they compensated appropriately to encourage them to stay long term? Are there other employees being groomed to fill into this role in that employee’s absence? Along those lines, are employees cross trained to do other types of jobs should their associates leave or a downturn cause the need to tighten the belt on expenses? 

Standard operating procedures: Are key business processes in the owner’s and employee’s heads or are they documented? This could include how to manufacture a product, sales processes, hiring and training manuals.  If not, will the product quality, service and pricing be consistent going forward?

Contracts: Many businesses have contracts with their customers or vendors.  Are the contracts assignable to a buyer? Will the terms of the agreement change upon the change of ownership?

Changes to customer agreements: Business just hit a historic high. However, it was driven by price increases or a decline in labor for customer support, not by customer growth.  Perhaps that is a good thing.  Or, perhaps it takes customers a year to find new vendors (think CPAs).  Price increases and changes to service agreements may benefit the short run but not necessarily be good for the long term success of the business.  Buyers will ask about recent changes.

As a business owner, you may be asking yourself, if I am getting penalized for things that happen in the future, will I also participate if the future’s success is rosy? It’s possible, but unlikely.  If a buyer enacts changes to the business that benefit the business, they want to reap the rewards of their hard work, not pay a Seller for them.  If a seller wants to participate in the upside post-close, it takes a strong case about the wheels that have been set in motion prior to the close. 

Two easy reads to explore this topic further are The e-Myth by Michael Gerber and Built to Sell by John Warrilow.  The common theme between this article and these books is to illustrate to business owners that to extract the best value, they need to work on the business rather than in the business.  It will make for the smoothest negotiation and highest price when it’s time to go to market.