Viewing entries in

Green, Yellow, Red: What Signals Investors

What’s not often discussed is the soft side of a deal - the people, their behavior, and what it signals to potential investors. It’s impossible to do a good deal with bad people, which means the personalities, proclivities, and oddities play a large part in dealmaking. 

We’re fortunate to see a lot of opportunities, over 2500 just last year, and are constantly in conversation with executives. This affords us the ability to recognize patterns and develop specific criteria of behavior that provide insights into an owner’s motivations, and subsequent corporate culture. Here are some of the signals and how we interpret them. 

The Small Business Crunch

The next 15 years will be the largest intergenerational transfer of private businesses in the history of the world. 2012 marked the first year that “Baby Boomer retirement” was the primary driver of business sales in the private lower middle market. Researchers have estimated that more than $10 trillion in business assets may be transferred by 2025.

We are in the beginning of a transition within the American economy where more than half of all businesses with employees will need to sell, restructure, or close their doors. The numbers are finite and inescapable. Mortality is a real thing. Liquidity issues and estate taxes don’t take care of themselves. Without a plan, the likely result is a legacy of chaos and confusion.

5 Questions To Prepare Your Business For The Next 10 Years

When you’re immersed in the startup world, it’s easy to get consumed by the here and now. You’re focused on rapid growth, scalability, and turning a profit. But once you’ve latched on to success, it’s important to think about the long-term viability of your company.

A recurring theme in recent discussions with our portfolio companies is what it will take to survive — and thrive — throughout the next decade. To find the answer, you have to start by asking the right questions.

Here are a handful of questions we’re considering to prepare for the future:

1. What is the singular, uniting focus of the business?

“Concentrate your energies, your thoughts and your capital.” — Andrew Carnegie

All businesses have roots, but most merely see the branches and leaves. While the branches and leaves are product lines or new projects, the roots are the core that is capable of sustaining the company even during drought conditions. Understanding your company’s core expertise and client base will help you understand where to put emphasis under what conditions.

2. What are we doing to delight our current customers?

“There is only one boss: the customer. And he can fire everybody in the company, from the chairman down, simply by spending his money somewhere else.” — Sam Walton

Acquiring customers is expensive, and making new relationships is largely unprofitable. Only when a customer becomes loyal can your business get the gross profit margin to drop to the bottom line.

In fact, increasing customer retention by a mere 5% can increase profits by 25% to 95%. (Yes, you read that correctly.)

3. Are we creating our future or waiting to be disrupted?

“In three years, every product my company makes will be obsolete. The only question is whether we will make them obsolete or somebody else will.”Bill Gates

There are two ways to look at a company: One way is to view the business as the aggregation of its products. The other is to view a business in light of the value it provides to customers.

The first way results in a Kodak situation, where the company was in the film and physical photography business. But what would have happened if Kodak had been in the “remembering moments” business? Digital would have been a natural transition. Perhaps it would have created Facebook or even Instagram. Instead of bankruptcy, Kodak could have rivaled every social network and tech company that exists today.

4. How would we fare during the next economic downturn?

“There will always be a business cycle, and white-collar workers will get hit in the next recession like they always do in recessions.” — Robert Reich

The next economic recession is not a question of “if,” but a question of “when.” In the next 10 years — perhaps even in the next five years — we will experience another economic downturn.

Where does your business stand in the value chain? Are you easily cut? Is your value quantifiable? Is your business a luxury or a necessity? These are the tough questions that will help guide your preparations. Taking precautions now may lower your profits leading up to a downturn, but it will allow you to still turn a profit when one occurs.

5. Are we operating as a bunch of individuals or as a team?

“Individuals don’t win [business]; teams do.” — Sam Walton

Teams are built on mutual respect, shared values, common goals, personal responsibility, and complementary skills. If your company is a group of individuals, that’s an area to start improving.

Tough questions can bring up even tougher answers. In most situations, the problems can be addressed. But occasionally, the damage is beyond repair. As Warren Buffett once said, “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.”

This post was originally published on Forbes.

10 Simple Tips To Make Your Business Acquirable

The last time I checked, the mortality rate continued to hover right around 100%, which means your business isn’t going to be yours forever. You’re going to sell it, shut it down, or pass it down a generation. An estimated 70% of businesses don’t have a family member capable or willing to assume responsibility. What are you doing to plan for the sale?

Here’s what you should do:

1. Check Your Ego: If you’ve built an acquirable business, you’ve had success. Congrats. You should be proud of your accomplishments. However, you should also be realistic in your self-assessment. As Charles de Gaulle once remarked, “Graveyards are filled with indispensable men.” Have a clear understanding of your role and how that role can be transferred.

2. Be Irrelevant: It’s counterintuitive, but one of the best things you can do to be acquired is prove that you’re irrelevant. Why? Your business is only worth what someone else can do with it. If you’re the glue, the strategy, the HR department, and the driving force, you’re screwed. A healthy layer of quality, non-owner leadership is key. The more you’re involved, the less your business is worth.

3. Become Known: Think of acquirers like clients. How will they find you? Being visible is the key. Attend conferences, participate in the community, and become a thought leader. There’s an old adage in acquisitions that says, “Never buy anything that’s for sale.” It’s highly unlikely the right buyer will magically appear, so treat potential buyers like potential clients and become known.

4. Develop Great Systems: Great systems allow you, or a potential buyer, to run the business without being present. Systems institutionalize expertise, leading to organizational consistency, quality, and true residual value. Again, your organization is only worth what someone else can get out of it. Spend time and resources on developing systems. It will pay off.

5. Clean Up the Financials: Van Halen, the legendary rock band, was notorious for its diva-like behavior, requiring a pre-concert bowl of M&Ms with all the brown ones removed. If they showed up and there were brown M&Ms, they refused to play. What does that have to do with your financials? Well, this high-maintenance behavior was genius. Van Halen’s setup required tremendous precision — even the smallest deviation could endanger fans and the band. If there were no brown M&Ms, no worries. But a single brown M&M meant other details were also likely skipped. It was their canary in the mine. For acquirers, financials are the canary. I’ve never seen a well-run firm with messy financials. Have them done professionally. Know them intimately. Be able to answer questions about them with ease.

6. Make a Profit: Despite gobs of wishful thinking, the value of all businesses comes down to one valuation methodology. Businesses are worth the present value of future cash flows. Let me repeat that: Every business is worth the present value of future cash flows, without exception. Your users, real estate, machines, systems, personnel, and customer relationships are worth the cash they will generate, discounted back to the present. Being profitable today clearly demonstrates earning potential and provides a clear pathway to a fair valuation.

7. Develop Reasonable Expectations: Unless your profits are exploding, or the business is pushing over $100 million in revenue, your company isn’t worth anywhere close to 10x EBITDA. For an average business, as measured by customer diversity, industry, and past consistency, with less than $1 million of earnings, your expectations should be between 3x and 5x EBITDA. As the size of revenues and profits increase, or the business becomes clearly less risky, the multiples can push upwards to 7x. Expect a portion of the sale price to be seller-financed and for some of the amount to be contingent on future performance.

8. Focus on Continuity: This applies to clients, partners, employees, and vendors. Little turnover shows stability, cohesiveness, and long-term value. The biggest danger in an acquisition is a lack of stability. The longer the tenure of your relationships, the deeper the roots, the better the communication, and the more grace you’ll have for the challenges that will inevitably pop up.

9. Be Transparent: During a recent potential acquisition, we received the requested information, and the deal looked great. We started due diligence and, lo and behold, the more we dug, the fuzzier things became. He calculated his net income by picking a number. He fudged his top line. He didn’t disclose big settlement payments for a significant legal liability. Ultimately, the truth comes out, so be transparent. Your acquirer will find it. Just disclose it — it will save you time and preserve your credibility.

10. Maintain Perspective: Please don’t send potential buyers reports about industry multiples derived from billion-dollar cash and stock transactions executed by multinational corporations. Not only is it not the same ballpark, it’s not even the same game.

This post was originally published on Forbes.

Deal-Making 101: The Basics Explained

“More than 50 years ago, Charlie told me that it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price.” -Warren Buffett

I’ve had the opportunity to negotiate some significant transactions. I’ve bought companies, organized partnerships, and sold large contracts. Each of these situations is a “deal,” where value is negotiated, and every deal is made up of the same underlying principles. Here’s how I view deal-making, along with some lessons I’ve learned.

The anatomy of a business deal is comprised of three basic components: the expected return, upside potential, and downside risk. Another way to describe this is to ask, “What do I expect to happen? What is the best possible scenario? What is the worst possible scenario?” The goal is to have a fair expected return, a huge upside, and very little downside.

Not Zero-Sum: To get a good deal, most people believe they must “win” and the other party must “lose.” If the only thing being negotiated is money, then yes, it’s a zero-sum game. But I’ve never been part of a negotiation where money is even close to the No. 1 interest of either party. The goal of creating a good deal for both parties is not only possible, but the only sustainable way to do business. It produces the best long-term returns for everyone involved.

Example: I will usually be very flexible on purchase price, but firm on guarantees like performance-based earnouts. I’m not trying to get a “screaming deal,” but instead, I want to pay a fair price for what I understand I’m receiving. The more money that is paid out over time based on performance, the less overall risk you’re assuming. Remember that the seller is always in a superior position of knowledge when it comes to forecasting the future.

Uncover Motivations: As humans, our motivations are always mixed and usually very complicated. A successful deal serves the primary motivations for everyone involved, so figuring out everyone’s real interests is essential. Some common motivations besides absolute dollars are fame/prestige, the well-being of employees, a consistent cash flow, promotability, risk mitigation, flexibility, titles, the duration of agreement, taxation, timelines, and culture/beliefs.

Example: The first question I typically ask is “If you could wave a magic wand and create your ideal situation, what would that look like?” The things mentioned are important; the rest is not. Focus on their important stuff to help them find satisfaction.

Best Alternative: A fundamental component to deal-making is to not only understand the worst-case scenario under the agreement, but also the worst-case scenario if the deal doesn’t get done. This is commonly called the best alternative to a negotiated agreement (BATNA) and largely determines the incentive each party has to make a deal happen. The question to ask is “What is my alternative if a deal doesn’t get done?” The better the alternative, the less you need the deal and the more risk you can take in negotiation.

Example: I always know my “bottom line,” based on my BATNA, and remind myself of it frequently. Deal-making can get emotional, which introduces irrationality. A good way to safeguard against impulsive decisions is to seek counsel from someone trusted and not emotionally involved.

Get Creative: The best deals are creative ones. Take stock of all your resources, and don’t be afraid to deploy them in unusual ways. The goal is to give what is less important to you, but more important to them, and to get what is less important to them, but more important to you. The negotiated terms are merely serving the underlying motivations, so think creatively about how to satisfy the other party’s real interests.

Example: I’ve negotiated on terms like personal loans, delayed payments because of divorce, extended time off to pursue artistic endeavors, and even a public apology for something I wasn’t involved in. Get creative to get the deal done.

Keep It Simple: Complicated deals hardly ever work, because complication creates confusion, uncertainty, misunderstandings, and, ultimately, hard feelings. The bulk of the negotiation should revolve around a few key points that serve the underlying interests, and the rest should be kept as simple as possible. After agreeing to something, define it. Even the simplest terms, if left undefined, create opportunities for confusion.

Example: I once negotiated for the former owner to have myriad sales incentives to keep her engaged in generating new business. I used the terminology “If responsible for X, you get Y.” She said, “Great,” and we moved on. Six months after we closed the deal, she said she was owed a significant sum for generating new business, even though she hadn’t been involved. She said, “Well, I coached the person who landed the deal, which makes me responsible for it.” Obviously, the term “responsible” was not clearly defined.

Get Personal: Despite the best negotiated agreement, the success of a deal ultimately relies on the people involved. Just because it’s in the contract doesn’t mean the person has to behave, which can cause a good deal to unravel quickly. The larger the deal, the more homework you need to do. Go to dinner. Play golf. Meet his significant other. Pay attention to how he talks about — and treats — the people around him. Deal-making is like dating, and your goal is to figure out what marriage would be like.

Example: One of the worst deals I ever did was one of the best-looking on paper. The only problem was the people involved. They came highly recommended, and although I didn’t click with them, I figured, “How bad could it be?” It was terrible. They turned out to be an emotional train wreck, mixed with poor ethics and illogical action. I literally shivered when I saw the name pop up on my phone or email. You can imagine how it ended.

Much of life is a negotiation, and deal-making is a central piece to business. I hope some of my experiences and missteps can help you make a better deal.

This post was originally published in Forbes.