According to the leading business multiple listing services, only about 30% of the businesses that go on the market each year complete a transaction. That’s a dismal success rate. Why do so few businesses sell and how can you avoid being one of them when you are ready to exit your business?
First, it’s important to understand that most businesses trying to sell each year are small, mom-and-pop businesses, listing for less than $250,000. The term “mom-and-pop” is a bit dated, so for the purposes of this article, let’s call these life-style businesses. They are generally stagnant with respect to annual revenue. They don’t grow much year-to-year. They are not very scalable. They typically operate locally and are primarily designed to provide their owners with a comfortable life-style.
Conversely, more than 70% of the businesses in the lower-middle-market do indeed sell. Most of these are small, profitable, privately-owned companies selling for $5M to $25M. For the purposes of this article, let’s call these small growth companies. They may not be seeing double digit growth year-over-year, but they at least have modest growth. They are scalable. They typically are not constrained by geography and are designed to create equity and build wealth for their owners.
You would think it would be easier to sell a life-style business, but the opposite is true. Most buyers want to buy growth companies. In addition to a low selling success rate because of no growth, life-style businesses are harder to sell for a variety of other reasons. The two biggest reasons are unrealistic valuation and poor EBITDA (Earnings Before Interest Taxes Depreciation and Amortization).
When buying a life-style business, EBITDA is practically non-existent, so buyers try to value it on Seller’s Discretionary Earnings (SDE), or “owner benefit”. Determining SDE or owner benefit can be a black art and often difficult to validate. Many life-style businesses don’t keep accurate books. That exacerbates the problem of achieving a successful sale in this segment of the business brokerage market.
As a consequence, life-style businesses don’t sell well because they are trying to sell into a headwind: no or low (provable) profits, no or low growth, and often operating in a local, saturated market. In contrast, well-positioned small growth companies don’t have to sell into a headwind. They ride a current of growth. They take advantage of a tailwind. And the best kind of tailwind is a strong TTM Tailwind: Trailing-Twelve-Months of solid revenue and profits.
So, the trick for life-style business owners wanting to sell is to reposition their businesses as small growth companies – to turn a headwind into a tailwind. And the trick for small growth companies wanting to sell is to create a strong TTM tailwind. In a future article, I will address how life-style business owners can reposition their businesses into small growth companies. In the rest of this article, I will address how small growth companies wanting to sell can create a strong TTM tailwind, to not only maximize their chances of selling, but to sell for the maximum price.
It all starts with a realistic valuation based on provable EBITDA.
Many buyers will “start” by valuing a company based on a multiple of earnings. I say “start,” because that’s only one metric. EBITDA has limitations in determining the actual performance of a business. It doesn’t account for growth potential, the value of intellectual property, and certain competitive advantages that a business may have over others in the space. Because EBITDA is often the starting point, small growth companies looking to sell are smart to use it as window dressing to entice multiple prospective buyers. The more buyers at the table, the higher the likelihood of a successful sale.
EBITDA is also used by lenders to determine if companies will be able to pay their future debt obligations. Since many buyers finance the purchase of a business, EBITDA becomes important in their ability to raise capital for acquisitions. In essence, EBITDA serves as a proxy for pre-tax operational cash flow. It provides a reasonable indication of expected cash flows post acquisition. The acquired company’s depreciation, amortization, debt, and tax liabilities often change as a result of a deal, so EBITDA removes those components from the valuation equation. EBITDA is also a standardized way for buyers to compare companies within their respective sectors.
All this is to say, EBITDA is the starting point for valuation and good EBITDA creates a stronger tailwind. Now, some buyers will insist on averaging EBITDA over three years, or at least trailing twenty-four. But no buyer can resist a strong trailing twelve months. When push comes to shove during price negotiations, especially with more than two buyers vying to submit the coveted LOI, one or both will default to TTM over trailing 24 or 36, and submit a valuation based on a multiple of TTM.
The single most important thing a seller can do is to present (and validate) strong trailing-twelve-months EBITDA.
There are a variety of strategies for boosting TTM EBITDA. Some are short term…not very sustainable, and probably easily outed by smart buyers. But they should not be discounted, because they will help get multiple competitive buyers to the table. Once they are at the table, EBITDA can become less of a factor to buyers once they discover the strategic fit. Said another way, good EBITDA gets buyers to the table, but a successful transaction is often the result of discovering the features and benefits afforded by the acquisition that buyers may not have seen without being at the table.
The more important strategies for boosting TTM EBITDA often involve systemic changes to how owners operate the business. This process typically starts 24 to 36 months before the owners put the company up for sale. They drive the top line and watch the bottom line like hawks. The strategies and tactics will vary widely depending on the nature of the business, the sector, and the objectives of the owners. The following is a small subset of strategic options for creating a strong TTM tailwind:
Trim the Fat, Reduce Expenses, Stick to Budgets
You usually can’t grow a business by reducing expenses, but you can usually improve earnings in preparation for a sale by doing so. In my experience, most owners can find 10%-20% of fat. Put your company on a diet. Make every manager stick to a budget.
Kill Pet Projects
You might be surprised to find out how much money is being spent on pet projects in your business. Every company has them. Whether they be new product development, prototyping, work-place improvement initiatives, or the CEO’s favorite charity golf sponsorship, these pet projects should be the first to go.
Sell-off Under-performing Assets
Got any old inventory gathering dust? How about unused patents, trademarks or domain names? Odds are, your business has an old product line, building, or other assets on the books that can be divested.
Reduce Salaries in Favor of Performance-Based Bonuses or Stock Options
Employee hates this strategy. Senior managers (maybe yourself) cringe to think about it. In my experience, many organizations are paying salaries based on old, outdated compensation plans with automatic increases, with little attention to pay vs. value. Some employees (usually the owners) are overpaid. Tech companies have successfully used this strategy since the beginning to fetch a higher multiple when selling. They shift cash compensation to stock options and/or performance-based bonuses.
Raise Your Prices
When’s the last time you raised prices? If you are striving to be the low-cost provider, or to stay at par with competitive offerings, then it’s a race to the bottom. Figure out how to raise prices by delivering extra value.
Focus on the 20/80, Fire Non-Profitable Customers
In many companies, 80% of the revenue is generated by 20% of the customers. In fact, an analysis may show that some customers are consistently not profitable, or low-margin. They cost the company money. Fire non-profitable customers, focus on increasing revenue through your best, most profitable customers.
Reduce Churn and Improve Cross-Selling
How much business does your company lose every quarter? Where are those customers going and why? The cost to acquire a new customer is usually much higher than the cost to retain the ones you have. Likewise, your existing customers are also the best prospects for your other products that they are currently not buying….perhaps don’t even know about.
Offer Incentives or Extend More Favorable Credit Terms
Every customer likes a deal. Make them an offer they can’t refuse. Offer incentives, or extend more favorable credit terms. Do whatever is within reason to increase your sales pipeline and your revenue.
Manage Travel and Entertainment Expenses
This is akin to reducing expenses, but deserves extra special attention. In my experience, there is often a considerable amount of money slipping through the cracks on T&E. It’s a gaping hole that should be filled.
If you operate in two or more locations, or have duplicate systems, you can often consolidate operations and find cost-efficiencies. It never ceases to amaze me how much duplication there exists in the smallest of companies. No more one-person offices. Time to get cozy.
Outsource Non-Essential Functions
Too many companies love to reinvent the wheel, or spend money on things that can be outsourced more cost-effectively. Remember, in a TTM Tailwind mindset, the objective is not to build, it is to position to sell. All non-essential personnel and operations should be jettisoned. No buyer wants to acquire a company and have to fire half the staff because they are redundant.
Okay, so that was a bit tongue-in-cheek. I was boring myself with the tediousness and often uninspiring process of boosting TTM EBITDA. But you get the idea. Creating a TTM Tailwind often requires changing direction. It can be uncomfortable, but the discipline to do it will result in a much better chance of selling your business, at a much higher price.
Assuming you have the discipline to it, you might benefit from my next piece. Because after you create a strong tailwind on TTM EBITDA, you’ll want to know how to zero in on a realistic valuation. So next, we’ll talk about the always-exciting topic of comps and multiples and plain-old psychological pricing. Stay tuned…