Capital Investments, Business Valuation and Selling Your Business

John Brown owned a successful janitorial supply company. After 22 years he decided to upgrade his facilities and made a major investment in a new office warehouse and all the related shelving, computers, and furnishings. John and his accountants estimated that the $250,000 reduction in yearly cash flow was more than made up by the likely long term return on investment from potential business expansion.

When John went to sell his business 9 months later he was shocked to learn that his improvements had:

Reduced the current value of the business at that time by 45% or $1,250,000.
Reduced the marketability of the business due to the increased debt.
Shrank the pool of prospective buyers who could buy the business.
All John could do was ask, “Why?”

The short answer is because the market values current available cash flow over speculative future growth potential. Let me explain.

During the planning meetings for this major investment, John Brown and his advisors forgot to talk about one detail. John Brown wanted to retire. He was so convinced that these investments would catapult the value of his business that he never brought up the fact that he wanted to retire. After all, according to his logic, anyone would be able to see the increased value created by all the new capacity. Unfortunately, his advisors just assumed John was going to run the place until he died, after all, “Why else would he invest all this money?”

Business buyers price businesses based on the future projectable cash flow discounted back into today’s dollars. Unfortunately, the future is not easy to see or predict. For that reason past cash flow tends to be the best indicator (or at least the one people agree on) of future cash flow. When John made this investment he significantly increased his future cash expenditures. Prospective buyers knew the expenses went up, but they were much more skeptical that the sales would grow at 20% for the next five years instead of the historic 10% from the last three years.

When John increased his yearly overhead expenditures $250,000 per year he reduced his business value by about 5 times that amount or $1,250,000. This reduction in cash flow lowered the amount of money available to pay off likely business acquisition debt. It also reduced the pool of buyers because the business now needed to be marketed to the limited pool of buyers would buy based on unproven growth potential.

The moral of the story is to make sure your business succession and exit strategy ties into the rest of your business plans. Human behavior and valuation theory rewards the highest cash flow at the time of sale over speculative growth “potential”. John and his advisors did everything right except realize that John had a short term horizon. A tragic misunderstanding that cost John two years of additional work and $500,000 of lost value when he did sell.

Often, working side-by-side with you for only a few hours, we can make sure your business plan both provides for future growth and creates the maximum exit value possible based on your personal goals and exit horizon.

Work with Professionals

If you have read some of our recent posts, we have focused on management and strategy techniques you can implement to improve your business. The advice is designed to cater to many different businesses in different industries.

Quality specialists such as a valuation expert, transactional attorney, an experienced business CPA, and a quality intermediary will help you focus on implementing these types of techniques in the best manor for your specific business.

Each plays a different yet essential role in making sure you get the best deal possible. To summarize:

Valuation Expert: Assesses the value looking at detailed history, projections, market conditions, and relevant comparative sales to determine the likely market sales price. If done properly this can be a valuable informational piece and sometimes a valuable negotiating tool.

CPA: Assist in organizing business records to ensure consistency and transparency so buyers will be comfortable they are getting quality information. If the buyer is not comfortable the offer will be crimped. CPA’s also provide detailed tax advice on how to structure the transaction to reduce tax burden.

Transactional Attorney: Their role is to inform you of the risks of your transaction and to protect you through carefully constructed written documents to the fullest extent possible. We have all heard attorney horror stories yet a quality attorney is helpful in any deal.

Intermediary: This is the sales and marketing team. They create value by identifying the most synergistic market for your business and then proceeding to generate prospects from that market and convert them to buyers. They make the deal and keep the process moving forward.

A proper team will enhance your sales price, reduce your downside risk, lower your taxes, and allow you to stay involved in running your business so profits and moral stay high. This is the best way to obtain an increased sales price for your business.

Tie up Loose Ends

Every business has multiple legal relationships that allow the business to operate. The most important of these legal relationships are reflected in important agreements such as leases, franchise agreements, bank notes, insurance policies and so on.

Do your best to make sure that each of these agreements is current. Make sure the provisions are reasonable. Most important, for things like leases, make sure that you have adequate time remaining and that it is reasonably transferable. If your business is location dependent you may not have a business to sell without three to five years left on your lease.

In a related issue if you have any pending lawsuits against you, try to settle them. Lawsuits spell uncertainly and disruption and carry a perceived risk far greater than the actual risk. If you can settle them that risk and the reduction in your sales price is gone.

Maintain Employee Moral

Anyone who thinks emotion is not a part of sales has forgotten about the last time they bought a new car. Were you “thrilled”, “upset”, “mistreated”, or what? This is emotion.

The final transaction has to make sense from an accounting standpoint in order to get financed. Yet emotion provides the drive so everyone in the process solves the problems and gets to closing.

Your people are your most important asset. If they are enthusiastic and motivated they are worth more than if they are lifeless and depressed. While we understand the importance of confidentiality we like to do plant tours when people are working. Businesses are more impressive when they are alive with people.

Your employees attitude will be felt by a buyer (whether they know it or not) and will translate into a higher or lower offer.

We are big believers in having employees work in their areas of strength. No one thinks anything of the fact that athletes spend 100% of their time in a very narrow specialty that they excel in, yet the common logic with business employees is that everyone should be cross trained. Certainly a few people need to be cross trained but encourage everyone to do the work they excel at.

Our last thought on employees is cut your staff down to fighting size. Too many employees reduce profitability and often reduce motivation. If your business has slowed down or you have installed labor saving technology, yet the staff is the same, they are all worrying about who is going to be let go. They are creating work and worrying that they will get caught. Solve the worry. If you don’t the buyer will. You can do it humanely and in all likelihood increase the value of your business.

Freshen Up Your Facilities

Just like you cleaned up your house before you put it on the market you need to clean up your business. Auto shops are the absolute worst about this. That old transmission that has been sitting outside your door may work great to clean the bottom of your boots but it is not going to help you sell.

Look at the entire operation with the eyes of someone who has walked in for the first time. Is it clean and organized? Are the colors and carpets still in style? Are there coffee stains on the carpet and places where the walls have turned grey from wear?

We cannot conclusively state that anyone has ever bought a business because it was attractive and organized but many businesses got the “drive-by” and never looked at again because they were a mess.