Advisory Insights – 55 Questions to Ask Yourself Before You Sell Your Business Part III

Our “55 Questions to Ask Yourself Before You Sell Your Business” series is designed to help business owners effectively prepare for the eventual sale of their business.

Owners who are considering selling in the future should think carefully about their business through the eyes of a prospective buyer.  The prospective buyer’s focus is on the future, specifically the future cash flows of the business.  Through this lens, owners can develop strategies to both enhance those future cash flows as well as effectively communicate a high confidence level in the future success of the company.

In this Part III of our series, let’s consider questions regarding revenues and profitability.

Revenue and Profitability Questions to Ask Yourself Before You Sell Your Business

  1. How predictable are my revenues and gross profits?

Predictability is the cornerstone of confidence in future results.  Some business models produce inherently predictable revenues and gross profits.  This is most often true of mature industries with stable pricing levels and steady growth trends.

Other business models, however, are lumpy.  Revenues are triggered by irregular shipping patterns, and gross margins can vary from customer to customer.  This is often true of custom manufacturers who fabricate, ship, and install large orders.

We encourage a close examination of the business in order to develop guidelines for revenue levels and, more importantly, gross profit margins.  This will likely require experimenting with analysis of different segments such as product lines, equipment vs. services revenues streams, customer sets, geographical locations, or seasons of the year.  To the degree that commonality and predictability can be established and proven in the historical financial record, these guidelines will be helpful in building confidence in a prospective buyer’s mind about future results.

  1. Are my revenues distributed among a wide range of customers, or do I have a high concentration of revenues from just a few key customers?

Concentration of revenues from only one or a few customers is perceived as a significant risk to prospective buyers.  The natural concern is the buyer might be unable to successfully “win over” the key customer(s), thereby damaging the economics of the transaction.  Another concern is that the key customer(s) will use the transaction as an excuse to shop their business to other competitors, thereby putting the revenue stream at risk of significant reduction or outright loss.

Often what appears to be severe customer concentration is actually a well-diversified customer base.  We recently worked with a company whose industry is dominated by only 4 customers.  Initially, this appeared to be a significant handicap to marketing the business to prospective buyers.  However, we determined that each of these customers divided their markets into 4 regions, each of which was a separate buying channel.  Furthermore, within each region, major metropolitan areas also operated as a separate buying channel.  Finally, we discovered that their customers also included architects, building owners, and real estate leasing agents.  While the total market was small by most standards, we identified over 200 potential customers, which significantly reduced the risk of customer concentration to a potential buyer.

In a sale transaction, i presenting this information up front to prospective buyers would head off discussions of valuation discounts caused by customer concentration.

  1. Am I the sales rainmaker in the business?

Another potential risk in a transaction is having all of the key customer relationships maintained by the current business owner.  Buyers will naturally assume that when the owner leaves the business, the customers will leave also.

Thinking about these questions 2 to 3 years ahead of any plans to sell the business is critical.  With proper hiring, planning, and nurturing, key customer relationships can be successfully transitioned to others in the organization and mitigate this risk.

For owners who fail to effectively plan for this transition, deal terms can be structured such that a portion of the purchase price is not released until a successful transition of key customer relationships is accomplished.  While not ideal for the seller, this alternative is usually better than an outright discount of the purchase, and it’s certainly better than no deal at all.

  1. Is my business beholden to one key salesperson who could easily move his relationships to a competitor?

One salesperson generating the majority of the company’s revenues can create major concerns for a prospective buyer.

Since the salesperson is probably deriving most of his compensation from these relationships, transitioning these customers to another salesperson is usually not a viable alternative.  However, in most businesses, customers also have key interactions with other members of the organization, such as sales support staff, installation or service technicians, or customer service representatives.  By planning ahead, the owner can create opportunities to deepen the ties between the operations’ staff and its customers in order to mitigate the risk of customer loss if a key salesperson leaves after the transaction closes.

Another mitigating tactic is to require salespersons to sign non-solicit agreements.  Owners should seek legal counsel to draft an effective non-solicit agreement in their respective state.

  1. Does my business have a strong source of predictable, recurring revenues?

The two best words in business are “recurring revenues”.  All other things being equal, businesses with multi-year customer contracts requiring fixed recurring payments drive the highest valuations.  The reason is simple: The buyer has great confidence those revenues will continue indefinitely into the future with minimal degradation as long as service levels remain high.

Because recurring revenue is such a driver of profitability and value, we recommend business owners spend some intensive time thinking about potential ways in which all or a portion of their revenues could be converted into a recurring revenue model.

For example, we recently met with a client whose business is overhauling turbo prop engines, an expense of $250,000 to $400,000 for the the operator of the aircraft.  Under the traditional model, the aircraft operators had to either diligently set aside funds for this expense or borrow money and repay it after the overhaul was completed.  This approach created a cash flow burden for the aircraft operator and a collection risk for our client.  Our client created a program in which the aircraft owner paid a small fee for each hour the engine was operated.  The fee was structured such that when the engine hours hit the point at which an overhaul was required, the cost was completely covered.  Since most of his customers earn revenues from operating their aircraft, the program matches the cost of the overhaul with their cash inflows.  Additionally, the cost of the overhaul can be discounted for customers on the “pay by the mile” program since there is no collection risk and our client can plan his shop maintenance workload months in advance.  In addition to the obvious current benefits, this client will enjoy an enhanced valuation when the time comes to market the company to potential buyers.

Finally, many businesses have a strong base of recurring revenues but may not realize it.  If a business can demonstrate that certain customers purchase relatively consistent amounts each month, quarter, or year (and have for several years), then these patterns should be documented and provided to a prospective buyer early in the sales process.

  1. Do I have good data to support my manufacturing and/or service costs, or do I run the business on my experience or “gut”?

Business owners develop a “gut-feeling” for their businesses.  Many successful owners can run the business without reporting systems because they know their costs of production by signing  vendor checks, funding  payroll, and  strolling through the warehouse.

A potential new owner will not have that “feel” and will desire to see good a reporting set to understand the costs of production, both materials and labor, overhead allocations, and optimum inventory levels.

Reporting systems that are developed early   can be refined, operationalized, and ready for a new owner to use to operate the business.

  1. Do I have an effective procurement process in place that is not reliant on my day-to-day involvement?

The “secret sauce” of profitability in many companies is the procurement process.  If the owner personally maintains all of the key vendor relationships and negotiates the favorable pricing arrangements which drive the company’s profitability, then those relationships need to begin to be transferred to other key leaders in the organization.

  1. Do I have an effective process to quote new business?

Good processes drive good businesses, and in most business-to-business models, the process starts with preparing a quote for the sale.  To convey confidence to a prospective buyer, the quoting process should include the following:

  • The same quoting tool should be used across the entire company, or at least by major product or service line
  • The quoting tool should have up-to-date cost information for materials and labor costs
  • The quoting tool should have a defined methodology for including overhead costs
  • The quoting tool should have built-in minimum profit margins and should require management approval to override
  • The quoting process should require larger project quotes to be reviewed by key management to ensure quality and accuracy
  • Larger project actual results should be compared to the quote in order to understand variances
  1. Do I ensure that my prices, including service rates, are updated consistently to reflect changing market conditions and increasing costs?

In an effort to keep customers happy and loyal, many business owners fail to consistently increase their prices to keep up with rising labor costs and market conditions.  As a result, profit margins may have been squeezed, investments in training or new technologies may have been deferred, and the quality of the labor force may have slowly degraded in comparison to competitors.  All of these outcomes make the business less attractive to potential buyers.

A few years ago while conducting due diligence for a client on a potential acquisition target, we inquired about the pricing of his services which was significantly behind market rates.  The target’s owner bragged that his customers loved his company and he could raise their rates without any problem.  It begged the question “Who is stopping you?”

Fortunately for my client, the strategic purpose of the acquisition was primarily to use the target’s services as an internal resource, but most other buyers would have discounted their offering price, knowing that it would take several years and probably a few customer losses to bring the target’s pricing up to market levels.

  1. Do I have good systems and processes to produce a backlog report?

Since the primary focus of a prospective buyer is the future cash flows of the company, it is critical to be able to efficiently pull together a backlog report.

Backlog is typically defined as sold orders for the future production and delivery of materials and/or the future provision of services.  In short, backlog is future revenues already sold.

It is important to both properly define backlog specific to your company and to develop processes and reports to calculate an accurate backlog on a regular basis, such as monthly.

In addition to sold orders for materials not yet shipped or services not yet rendered, many backlog calculations include the following:

  • The annual value of contracted recurring revenues
  • The annual value of non-contracted, but highly predictable recurring revenues
  • The remaining value under long-term contracts, such as construction contracts

Some business models have very large backlogs in which revenues are highly predictable for the next 6 to 18 months or even longer.  Other businesses have short backlogs of 30 to 60 days before existing orders must be replaced with new ones.  The key is to have this information available and to be able to demonstrate to a prospective buyer the ebbs and flows of backlog levels through various business cycles and seasons.

  1. Is my business growing consistently?

It should not be a surprise that growing businesses are more attractive to prospective buyers than flat or declining businesses.  Growth is typically a sign of health as the business is able to keep up with its market or maybe even take market share from competitors.  A history of modest or strong growth gives the prospective buyer confidence that his investment can be recouped more quickly.

We recognize that the market does not always allow for growth and in some instances, business owners are reluctant to invest time and effort into opening new markets or establishing new product and service lines.  However, for those owners who are planning on a potential sale of the business 2 to 4 years into the future, we believe that modest investments of time and financial resources toward achieving growth rates at least equivalent to the market will be rewarded with higher valuations for the company.

  1. Is my business seasonal?

Seasonal businesses present unique  challenges, and business owners should recognize that prospective buyers could be discouraged from moving forward with a transaction if the potential risks associated by seasonality are not mitigated.

Typically, seasonality requires an increased level of planning and investment in working capital.  The current owner should document and explain how decisions are made and how resources are allocated to properly plan for seasonality in the business.

  1. Do have a process to forecast my future operating results?

One of a prospective buyer’s first requests is to see a forecast of the business’ future operating results.  Very few transactions will proceed past introductory talks without the buyer knowing the current owner’s perspective of the near-term future of the business.

We highly recommend preparing for this request by creating an annual forecast of the next 2 to 3 years of operating results and by updating the forecast at least semi-annually.   Identifying and documenting the key assumptions built into the process is important.   Predicting results past the next 12 months is highly subjective and carries substantial risk, but the process and habit of thinking about the future will create important disciplines inside the company that will be attractive to prospective buyers.

The most valuable companies in any industry are earning an above average profit, are growing at least as fast as their market, and are demonstrating that they can predict their results based on a set of reasonable assumptions about market conditions.

In Part IV of our “55 Questions” series, we take a closer look at questions surrounding Financial Condition and Capital Structure.

We recently discussed our “55 Questions” with Gordon Deal on the “Your Money Now” podcast.  You may listen to the podcast here.