Value Drivers: Building Reliable Systems to Sustain the Growth of the Business

If your objective is to someday sell your company for the highest possible price, you would be well served by building reliable systems that can sustain the growth of the business.

A solid management team is the first value driver to focus on when you are preparing your business exit. In addition to building a strong management team, it is important to build reliable operating systems that can sustain the growth of the business. The second value driver then is the development and documentation of business systems that either generate recurring revenue from an established and growing customer base or create financial efficiencies. For most businesses, this includes all of the core processes that generate revenue or control expenses. These systems may include processes related to production or service delivery, but also may include people-related processes such as a succession planning or a performance management approach.

Look at your business from a buyer's perspective. If you leave shortly after a sale, what remains? If the answer is top management and highly efficient business systems, you can be more confident that you will be able to get top dollar for your business.

In addition to the business systems related to revenue and expense, some systems are related to customers, such as tracking systems, and the delivery of your products and services such as distribution systems. The documentation of these systems is important to ensuring that quality and consistency can be maintained after the sale. They also signal to the buyer that elements critical to the successful transition of a business are in place. Some examples of items worthy of documentation are:

· Financial control systems and accounting policies.

· Policies to ensure compliance with legal and regulatory matters, especially those related to employer/employee relationships and safety.

· Data management and information systems that tie the company together.

There are several business systems, which, once in place, enhance business value whether you plan to sell your business now or decide to keep it. These systems include:

· Human capital management including: recruitment, selection, hiring, and retention; performance management; training and development; compensation and benefits.

· Production including product or service quality control and improvement.

· Product or service research and development.

· Inventory and fixed asset control.

· Sales, marketing, and communications.

· Procurement including the selection and maintenance of vendor relationships.

Obviously, appropriate systems and procedures vary depending on the nature of a business, but at a minimum, those resources and activities necessary for the effective operation of the business should be documented. After you have built reliable systems designed to sustain the growth of the business, the next value driver to focus on is establishing a diversified customer base.

Preserve and Protect Your Business On All Fronts

Today I would like to discuss four areas to preserve and protect business value:

Reducing Expenses
Minimizing Risk
Minimizing Taxes
Ensuring Business Continuity

Expenses
Most owners have, by now, taken action to eliminate non-essential expenses. These actions, or reactions to the faltering economy, typically include terminating or laying off employees, reviewing company financial information, eliminating “perks,” and reducing and/or eliminating employer contributions to 401(k) plans. If you would like more information about what other companies are doing to reduce expenses, please contact us.

After the initial round of expense reduction, there may be more you can do — even if you have resuscitated your company’s cash flow. Cost cutting increases gross margins, increases cash flow, and thus increases business value. Second-round cuts often include benchmarking expenses to industry standards to see if they vary significantly from industry norms. If they do, owners are asking the hard question, “Why?”

Another strategy is to subject employee costs to further scrutiny. For many businesses, labor constitutes a huge chunk of their budgets, but for all business owners, having a successful, motivated management team in place is critical to a successful exit. Because balancing these two is no easy task, many owners are conducting employee-by-employee reviews, are re-aligning salaries and incentive programs and evaluating whether their current employees are the best ones to meet today’s economic challenges.

Risk
Every company faces risk from both inside and outside its doors. Today’s economic climate, however, has increased the level of risk that many companies face from claims of discrimination by laid-off employees, employee fraud, or patent infringement by desperate competitors.

While many owners see their Property & Casualty (P&C) premiums as a great place to cut costs, they forget that their exposure to risk is heightened and their ability to absorb a claim (given their weakened financial state) is compromised. Consider meeting with your P&C firm to examine deductibles and coverage limits, but this year, ask questions about the strength of the insurer and its loss reduction programs.

Smart owners also are taking a close look at the financial condition of their suppliers and customers. Especially if owners have depended on a small number of suppliers, or if suppliers are in an especially hard-hit industry, owners are diversifying their supplier lists. They also are reviewing credit-granting policies, updating them as necessary and most importantly, adhering to them.

Many owners find themselves on the receiving end of “let’s talk about that line of credit” calls from their bankers. Others are pre-empting that call by creating written plans that show how their companies will respond to today’s challenges. They are sitting down with their bankers to examine those plans and often renegotiating the payment terms of their loans.

No discussion of risk is complete without considering the personal component: Do you have a plan to protect your personal assets? And, does that plan include ensuring that your family receives full value for your company if you do not live to sell or transfer it? Since each owner’s situation is unique, we encourage you to schedule a time for a frank conversation with your advisors about your family’s exposure to risk.

Taxes
Every new presidential administration brings with it new tax rules affecting your company. Under the Obama Administration, the rules governing the treatment of net operating losses have changed as have those related to the built-in gains assessed in conversion from a C to S corporation. If you haven’t already done so, take time to talk to your CPA about his or her ideas about how these (and other) new rules can reduce your personal and company’s tax liability.

Business Continuity
This last area of protecting your company during tough economic times is one that many owners overlook: business continuity. Is your business continuity plan appropriate for the current value of your company? Many owners created their plans when all they could foresee was growth. If that is your situation, we remind you that the disability or departure of a co-owner could have a devastating affect on your company. The departing shareholder will want his or her buy-out at the highest reasonable value — one the remaining shareholder may simply be unable to pay (given cash flow constraints) or, in this credit market, unable to finance.

Unless your business continuity plan specifically states that the value of the company will be its fair value — as determined by an impartial appraisal — on the date of the triggering event, one of you (the remaining or the departing shareholder) will be unfairly harmed and the other unfairly enriched. So, pull that business continuity agreement out of your bottom drawer and read it carefully.

Tough Times Crown Cash Flow As King

In the previous issues of this newsletter, we outlined two of the four areas where business owners who want to both survive in today’s economic climate and emerge from it poised for growth (or sale) can focus their energies. As you may recall, the areas we have already talked about are creating value and creating revenue. Today, we discuss the third area: quantifying cash flow.

As you consider ways to meet today’s economic challenges, a vital first step is to focus on company cash flow.

What do we mean by cash flow? The amount of cash left over after the company has paid its expenses. Common add backs to cash flow include:
• Excess Compensation
• Shareholder Distributions
• Owner Perks
• Retained Earnings Additions
• Depreciation and Amortization deductions

We recommend that you take a hard look at your company’s monthly cash flow statement. Do you really understand what it is telling you? Today every owner must become an expert in reading cash flow statements. If you are not as comfortable with your company’s financial statements as you are with your favorite novel, ask for help. Your CPA can quickly teach you to “read” or analyze your financial information so that you can quickly determine, on a monthly basis, your company’s cash flow.

Why is cash flow “king?”

Cash flow has always been hugely important in both running a successful company and in orchestrating its successful sale, but today cash flow is king. Why?

1. Cash flow is the lifeblood of a company. Owners must understand —and be able to measure —where cash comes from and where it goes. It is an accurate indicator of the financial health of your business. Unlike more subjective measures, it makes no assumptions and entertains no preconceptions.

2. For the reason stated above, cash flow is a critical component of what your bank wants to see. Unless you are able to accurately establish current cash flow, banks will be reluctant to grant or renew financing.

3. Quantifying exactly how the current economy has affected your company’s cash flow (as opposed to just revenue) provides a credible way for you to predict the impact of further expense reductions, strategies to improve revenues or strategies to improve gross margins. If you don’t know —at this moment —your company’s cash flow position, you cannot effectively manage your company and you can’t predict or project future cash flow.

4. The financial reason you are in business is to grow shareholder value. Shareholder value grows as cash flow increases.

5. In troubling times, employee fraud (such as embezzlement of company funds) tends to increase. The best way to detect fraud is to review cash flow/financial statements on no less than a monthly basis. We are assuming, of course, that your company is producing monthly financial statements. Anything less frequent than that and you run the risk of not reacting to something that “isn’t quite right” as quickly as you should, and not knowing where your business is or where it’s heading.

Once you’ve got a handle on current cash flow you need to create, based on today’s economic climate, a projection of future cash flow. Begin with an accurate picture of current cash flow. Then, create three projections: one for the best-case scenario, one for the worst and one for the likeliest scenario. All of those projections should include assumptions about:

• Customer Expectations/Policies
• Supplier Options
• Actions of your Competitors
• Profitability
• Pricing
• Product Lines
• Equipment Replacement

Keep in mind that your employees may not be able to create these projections. They may have their hands full managing the day-to-day issues. If that’s the case, seek the help of your CPA, or consider hiring someone on a temporary or project basis. These projections are simply too important to put off until next week, next month or next quarter.

Indecision: The WRONG Decision

“I haven’t decided what I ultimately want to do with my business, or when I want to exit, or how much money I’ll need, or whom to sell to, so how can I plan my exit? Besides, I don’t want to exit right now.” If you’ve said this, or thought it, you are not alone. Many business owners are either overwhelmed with the thought of exiting or are so busy fighting daily business fires that they think they cannot plan their exits.

Know that in your indecision, you are making a decision. As Winston Churchill observed, “I never worry about action, but only about inaction.” When you take a passive attitude toward the irrefutable fact that you will–one way or another–leave your business, you are deciding to settle for a least profitable exit for yourself and for your family.

If you are an owner who isn’t sure about what you want, or when you want to leave, why is it so important to decide to act today? Why can’t you wait?
Preparing and transferring a company for top dollar takes time—on average about 5 years. Most of those years will be spent preparing the business for the transfer. If you decide to sell to employees or children (two groups who rarely have any money), they’ll need that time to earn the money to pay you for your interest.

More time often equals greater reductions in risk. Time can be used to design and implement income tax-saving strategies, build value, strengthen your management team, begin a gradual transfer of ownership (not control) to key employees or children. If you wait too long, you probably won’t have time to implement these strategies and you’ll likely end up transferring your business on less-than-ideal terms.

The market does not operate on your schedule and may not be paying peak prices when you are ready to sell to an outside party. Witness the state of the M&A market in 2008 and 2009: activity is almost non-existent in many business sectors and down in almost all.

If leaving a company you’ve worked so hard to build and having little or nothing to show for it, is unacceptable to you, let’s look at a few of your options.

Wait for a buyer. According to Deloitte's Entrepreneurship UK: 2008 survey, 35 percent of business owners said they will wait for a third-party offer for their businesses. Owners in this group believe that one day a buyer will contact them, negotiate a sale, and that will be that. Well, this is a decision of sorts—but one that flies in the face of reality. While few businesses are being sold today, there will likely be a significant number of Baby Boomer business owners vying with you to sell their businesses when the M&A market recovers.

In a competitive buyer’s market, only the best-prepared businesses sell for top dollar. And the owners of those well-prepared businesses will be those who made the decision to act to prepare their company years ahead of the actual sale.

Liquidate. Liquidation is a common exit path for owners of companies whose cash flow is flat and has little probability of improving—absent the design and execution of a business/exit plan. If you find yourself in this group, we recommend that you meet with your tax and other advisors to do the planning necessary to create the most tax-efficient liquidation possible.

Decide to exit and plan accordingly. Start today and take the following steps:
1. Fix a departure date.
2. Determine your financial needs.
3. Decide whom you want to succeed you.
4. Have your business valued to see if: a) should you sell today; and/or b) it has the value necessary to meet your financial and other exit objectives.

Deciding to do something now to create the best possible exit path is not difficult. The failure to act, however, can potentially be fatal to a successful exit. The success of your business exit is simply too important to you (your family and your employees) to leave to chance. Why wait? Why decide not to decide?

It’s Never Too Early to Plan Your Exit

Most entrepreneurs are so excited about starting and growing their businesses, they often forget the end game until it’s too late. Proper exit planning can help maximize the value of your venture, minimize the tax consequences of the transition and allow the business owner to control the process. Here’s a sad but all-too-common story about a hypothetical business – Stevenson Consulting – to illustrate our point:

Mike and Bill Stevenson were two owners of a thriving IT Consulting company. What began as a business planning meeting quickly turned into a discussion about: “We’re getting out of business, how do we do it?” As successful as they were, they were tired of staff issues, changing technology, and the day-to-day grind of running a multi-million dollar company.

A sale to a third party was not an option because Mike and Bill were not willing to stay on after a sale. And they had failed to develop a strong management team, which any savvy purchaser would require as a condition of purchasing the company. Transferring ownership to a group of key employees was also out of the question. None had been groomed to take on this type of responsibility and nothing had been done to fund this type of buyout.

Neither owner had children who were experienced enough to take over the business, so their only remaining option was to liquidate.

Mike and Bill’s highly profitable company had little worth beyond the value of its tangible assets. After the sale of those assets, dozens of employees lost jobs, the business disappeared, and Mike and Bill left millions of dollars on the table.

You’ve put your energy and your capital into building a business. This business most likely accounts for more than 90% of your net worth. Why not protect that investment so that it can be monetized on your terms? Learn how ClearCourse Consulting’s Exit Planning practice can help you prepare for the most important financial event of your life: the transition out of your business.

Planning for a Rainy Day

There may be nothing worse for a business than to have its owner suddenly die. . . especially if it's your business.

Let's look at what can happen when an owner dies.

Joe Carpenter was the 55-year-old sole owner of a successful construction company. Joe hoped to sell his company to a third party in the next 18 months.

What Joe needed was a way to ensure that his company would survive if he died or became disabled during that period. Before he could put any plan into place, Joe was killed in a traffic accident. Soon after his death, key employees left his company for jobs with more certain futures. They feared that the company might not continue without Joe's leadership and personal financial backing.

Their departures caused a decrease in revenues, as well as the default on a number of contracts, which exposed the company to significant liabilities. Long-time customers grew uneasy with what they perceived to be a rudderless ship and took their business to Joe's competitors. Joe's bank grew uneasy as well and decided to call in his company's debt — debt Joe personally guaranteed.

Within weeks of Joe's death, his key managers were gone, his company defaulted on a number of contracts, revenues plummeted, customers jumped ship and any prospects of securing replacement financing quickly disappeared.

As you can see, business continuity planning is vitally important to your company. Without a well thought out "survival plan," the consequences to employees, customers and most importantly, your family and estate are dire. (Don't think that your estate will escape the notice of your business creditors.)

Fortunately, there are a number of methods sole owners can implement today to help avoid the type of business collapse that Joe Carpenter's business experienced.

First, to keep key employees on board after your demise, offer ownership — perhaps via a buy and sell agreement, or offer additional compensation if key employees continue to run the company. The amount of compensation can be directly tied to company profitability and continued success. As an additional incentive, offer these employees a substantial bonus (called a "Stay Bonus") for staying with the company — one that can be funded with insurance and that can be accessed in case of your death.

Second, alert your bank to your succession plans. Meet with your banker to discuss the arrangements you have made and show him or her that insurance to affect these plans is in place. Make sure your creditors are comfortable with your succession plan. Ask them what arrangements they would like to see in place.

Third, create a written plan that states: 1) who should take on the responsibility of running the business; 2) whether the business should be sold (if so, to whom) continued or liquidated; and 3) who your heirs should consult regarding the sale, continuation or liquidation of the company.

Finally, work closely with a capable insurance professional to make certain the necessary insurance (such as funding the Stay Bonus) is purchased by the proper entity, (you, your trust or the business) for the right reason and for the right amount.

What would you pay for your company ?

Did you ever look at your company from a buyer’s perspective? Would your business be attractive to a buyer? At what price?

Even if you have no plans to sell your business, these questions are relevant. If you begin to do the things that will maximize the value and attractiveness of your business to an outside buyer in the future, you will also improve your results today .

I recently helped a client with the purchase of a local manufacturing company. Had the seller considered these questions three years ago and taken action, he would have been able to easily add several million dollars to the sales price. He also would have made the transaction easier to close.

So you’re not planning on selling your business in three years, why worry about it now?

When you look at what makes your business valuable and attractive to a buyer, financial results such as cash flow, EBITA, revenue growth and consistency, and market share are some of the most obvious components of value. These are metrics that command the constant attention of most CEOs even if no sale is anticipated.

Non-Financial factors:
There are many non-financial factors that contribute to the valuation and attractiveness of a business. The following is a list of several common non-financial business issues that may reduce the value of a business and make it less attractive to prospective buyers. Improvements in these areas will add value when you go to sell and pay dividends as long as you own the business.

Dependency on you - if your presence in the business is critical to its continued health and success, you have a job and not a business. Buyers will see this as a big negative when considering the value of a company.

Dependency on one or a few customers – in most industries, if you have a client that accounts for more than 25% of annual revenues, future revenues are riskier than they would be by a more balanced customer base.

Insufficient systems, procedures and performance indicators – how well has the business been systematized. Could someone from outside the industry transition into leadership easily? If the business has adequately been systematized, the core processes of the business have been documented and possibly automated. The impact of loosing one or two key people has been reduced because the knowledge is in the business, not just in a few key employees.

Weak or inaccurate financial reporting – nothing slows down a buyer’s due diligence like poor or incomplete financial reporting. It raises immediate red flags with buyers, bankers and investors.

Action steps:
Take a break from the day to day challenges of running your company and put yourself in the shoes of a buyer from outside your industry. Make a list of the challenges you would face buying the business in its current condition. Turn that list into a roadmap for improving the current and future value of your company.

The January 2007 issue of Inc. Magazine has a business valuation guide that looks at 147 different industries. For each industry it notes the number of businesses sold in the survey period, the median annual revenue and sales price, and the industries three best valuation multiples.

Example:
For Computer Related Services, the best valuation indicator is 5.41 x Discretionary earnings (Net income + taxes + interest expense + owners compensation + non-cash charges), the second best valuation method is 1.34 x net sales. Determine your companies approximate value by averaging the 3 indictors provided for your industry. These indicators are a good starting point and the ultimate value will depend on many factors including the non-financial factors listed above.


“The general who wins the battle makes many calculations in his temple before the battle is fought. The general who loses makes but few calculations beforehand."
--- Sun Tzu