Selling a business is different than selling anything else, and your prospective buyer will closely scrutinize your business before they make an offer. Are you ready for that level of examination? Jim Grebey helps you get ready in this article originally posted here. (re-posted with permission)
In part one of this three-part article, we discussed the reasons for positioning a business prior to an M&A event. Here we will discuss some of the critical steps that should be included in the positioning process. Whether you are seeking a full exit or looking for a capital partner who would leave you responsible for continuing the businesses operations, these activities are intended to shorten the sales cycle and improve the business’ value proposition.
Let’s start with an assumption: any time you fail to thoroughly answer an investor’s due diligence question, you will appear unprepared, and that lack of preparation will lower the business' value proposition because it can put you at a disadvantage during negotiations. You may have built a great business that is growing quickly, but if you’re not prepared to definitively explain your business model, you risk the investor not understanding the business' true value. Or if they do understand the value proposition, they'll think you don’t understand the true value of the business and offer you a lower price as a result.
Step #1: Operations Assessment
You must enter the M&A process from a position of knowledge and strength. You accomplish this by performing an operations assessment to identify potential risks, allowing you to negotiate from a position of strength rather than ignorance, and an investor will not be able to use this as leverage.
For instance, if an operations assessment indicates a weak sales organization, an investor will likely use this and lower their offer because of the presumed expense to solve the problem. By understanding the weakness, you can convert this to a position of strength by looking for an investor seeking to merge the business into a group with a strong sales team who is more likely to understand that your value proposition is in the strength of your product, not your sales team. You’ll be prepared and ready to show that you have already factored the sales risk and you will have turned a negative into a positive. An independent operations assessment can be a valuable positioning tool.
Step #2: Business Model Analysis
The next step in positioning needs to be an analysis of the business model so that it can be clearly explained to a potential investor. This requires understanding, not only of the strengths of the business, but its weaknesses as well. Telling a prospect that they may want to make an additional investment to improve sales can be a tough conversation, but you may want to show that there is greater potential than the current financials indicate and be able to show the upside without sales looking like a negative. If you appear unaware that sales is a weakness, you are responding from ignorance and have no negotiating position. The goal is not to be surprised by an investor's findings.
Step #3: Review and Recast Financials
The third step in positioning is to review your financials and recast them to present a realistic valuation of the business. Recasting of the financials is needed to determine what the normalized expenses and income are for the business and making adjustments to the financials to move any expenses or income that will not be normal to the continuing business. Recasting moves these expenses and income below the profit line, meaning a new owner would not incur the same expense or income. These are the Adjustments in calculating your EBITDA.
Small and startup businesses are notorious for expensing personal items. Does the president receive a company car as a benefit? If so, that car expense will lower the EBITDA if it is not moved below the line. This is a value proposition discussion, not a tax discussion. Remember, you will be negotiating a multiple of EBITDA to determine the value of the business, so you will want to eliminate that expense from the calculation. The same is true on the income side. Did you spin off an asset or offer a product that you received income from but which will not be part of the continuing business? That income needs to be reflected as an income adjustment.
This is a good time to have your CFO or CPA review what items have been capitalized versus expensed and the value of deferred sales. Small, valid changes can have a large effect when a multiple is applied, so decisions about these items need to be considered well in advance. This is one of the more critical areas that should be considered when you are considering long-term versus short-term strategic path analysis.
Step #4: Prepare a Pro Forma
The next step is preparing a realistic pro forma. Your financials show the past performance of the business, but the value proposition of a business exists in a continuum between the past performance and the future performance of the business. It is a projection of financial performance for at least the next three years. The pro forma should be based in fact and not appear like a game of liar's poker. If the business has been self-sustaining and has grown 15% annually in the prior three years and you are projecting a continuation of that growth over the next three years, you have a pretty sound basis for your projections. If, however, you’re projecting more than 50% growth annually over the next three years, you have some explaining to do! If you can show the current growth track modified with additional investment and show the potential income change, you will create a strong negotiating position for a higher multiple. If the business generates a monthly recurring revenue then the value proposition should be based on an annualized multiple of the December revenue rather than simply using the actual January to December revenue.
Read more in part three of this series where we explain the final three steps you will need to perform in order to effectively position your business for sale and improve its value proposition.
Jim Grebey is president of Diligent Inc., which provides positioning services for small businesses preparing for a sale and operations due diligence services for investors. He is the author of Moving On — Getting the Most from the Sale of your Small Business, published by DeGruyter, and Operations Due Diligence — An M&A Guide for Investors and Businesses, published by McGraw Hill
Content originally posted here.