Plain Talk about Exiting Your Business: The Needs Gap and the Value Gap

[Editor's Note:  There is a lot of misinformation about the state of the market for lower middle market ($10M to $200M in revenue) companies looking to sell - either now or sometime in the next few years. I asked some of our clients to provide questions that were on their minds. Answers have been provided by private equity firms, intermediaries, business owners, and bankers.

While good, well-managed companies are being sold at close to record prices, this article addresses a problem for companies looking to sell -  how to address a "value gap" or "needs gap" that has developed between the current market value of their business and the amount they need or expect to get from a sale.

If you have any questions about this information or a question that we did not answer in the following, please do not hesitate to contact us. -DPM]

Question: How do I determine if my company has a value gap or needs gap?

Answer:

What many companies looking to sell are experiencing is called a "value gap" or "needs gap." This means that the company as it is performing or configured today will not achieve the sales price in the current market that it would have earlier before the 2008-12 downturn. This gap is the difference in value between then and now.

Question: How do I know the current value of my company?

Answer:

We suggest to our clients that they contact a reputable investment bank or M&A intermediary who can estimate a market valuation range for your business. This market valuation is very different than a valuation that an organization might do for estate planning or tax purposes. An M&A intermediary will value your company based on the current market for companies of similar size, industry, performance, and growth. A common mistake that owners make is comparing their company to the valuations of large publicly-traded companies in their industry. The truth is that large companies trade at higher valuation multiples - sometimes much larger multiples - because risk is generally perceived as significantly lower than with smaller companies. An M&A intermediary or investment banker can determine the appropriate market valuation range for your business.

Question: OK, so now I know the estimated value range for the business. Now what?

Answer:

Once a business owner knows the estimated value of the company, it's time to figure out how much the owner gets to keep and to determine if that's enough. Consulting with a competent tax accountant, you can calculate the net proceeds which is the estimated gross value of the business less the legal, accounting, and intermediary costs to sell the business, less the tax bite that Uncle Sam may take. [Many times there are built-in gains in the business that may make that tax bite significant - and your accountant and wealth management professional may be able to suggest ways to mitigate this BEFORE you sell.] Once you've determined the net proceeds, it's time to review this with your wealth management professional to determine how you might invest the proceeds to see if you will be able to support the lifestyle you expect.

Question: What if it's not enough?

Answer:

Then you and your wealth management professional must determine how much you do need. We then help clients develop a strategic growth and execution plan for the business, with specific steps necessary to achieve the increase in valuation in order to meet the owner's needs.

Question: Is that the needs gap?

Answer:

Yes. It is the difference between what an owner may need from the net proceeds of the company and what it's currently worth.

Question: Then what is the value gap?

Answer:

The value gap typically occurs when a company's performance slips. A company may have had a valuation of $1,000 in 2007, based on certain performance projections for growth of revenue and cash flow. If the company has failed to meet those projections for 2008, it may now only have a valuation of $700. That difference between the previously "expected" value and the current market value is the value gap. The gap may actually widen if buyers begin to suspect (or even imagine) that the business may have additional unknown risk. It is an uncomfortable place for all parties and typically the company is taken off the market.

Question: So what happens with a needs or value gap? Am I stuck staying with the business?

Answer:

Please note that in some cases, it may not be possible for a business to grow sufficiently to add enough value to meet an owner's needs, due to an aging industry, product obsolescence, etc. If that's the case, however, business owners tell us they would rather know that as soon as possible so they can possibly take other steps.

However, we have been pleasantly surprised over the years at how many businesses can actually achieve their needs with a good plan and great execution. Many businesses become a "lifestyle" business over the years, supporting the income needs of the owner. As a lifestyle business, many companies are worth more to the owner than to a prospective buyer looking for a return on investment. By focusing on the primary drivers of value for the buyer, a business can be transformed into a much more valuable entity.

Question: What are the drivers of value for the buyer?

Answer:

What are buyers looking for? It comes down to four things:

1. History of revenue and profit growth

2. Strong cash flow or EBITDA

3. Strong management

4. Opportunities for growth

In order to get the best price, you must be able to present a company that the buyer can see will bring them a reasonable return on their investment. That means the business has to have the potential to grow and has management that is knowledgeable in the industry that will help them grow the business. For more detail see "Prepare your company to be bought."

Question: Does that mean that businesses that don't have the four value drivers won't sell?

Answer:

No, but what is true is that flat businesses, or those with an inconsistent history, are less desirable and therefore are typically "discounted" by buyers. Businesses without the four drivers have a higher risk of not meeting the desired investment return. Simply stated - higher risk means a lower price.

What is happening in today's market is that buyers are being more selective and those companies perceived as "less desirable" are either not sold because banks will not provide debt financing, or they are being deeply discounted.

Question: How long does it take a company to transform from a lifestyle business to a value business?

Answer: That depends on a number of factors. Based on the dozens and dozens of companies Mead Consulting has worked with, we would say it comes down to 12/24/36. That's 12 months, 24 months, or 36 months. We have found that by focusing company management on the key drivers, an organization can be ready to go to the market in as little as 12 months, but more typically it's 24 or 36 months. See"Maximizing Company Value at Exit."

We assist a company with direction and resources, but a lot depends on the commitment and discipline of the owner and management team. We tell business owners that there is no magic button to push - it's hard work. But, most successful owners agree that it's worth it. Many times, we can accelerate the process by helping the owner stay focused and hold himself and the management team accountable for progress.

Question: How much progress can a company make (over 12/24/36)?

Answer:

We've seen companies with needs gaps improve valuation by as much as 500% over 36 months. A $50M revenue client company that sold in 2006 had a 16X IMPROVEMENT IN EBITDA between 2002 and 2005. Another more recent client valued at $16M in early 2012 sold for $80M in 2014. While these situations are possible, it is more typical to see improvements in value of 30% - 50%.

Question: As a business owner, what should I be doing?

Answer: Act Now! This is a Sellers' Market. The stock market is at record highs, borrowing costs are very low, there are more buyers than sellers, and both private equity and strategic buyers have stockpiles to invest. Most people believe that the dynamics of this "sell cycle" which began in 2012 cannot last more than another two to three years. Start today to work on preparing your business to meet the four value drivers. Only those companies that are well-prepared will gain a top price; the others will, at best, sell at a steep discount.

For more information, also see "Common misconceptions about selling a business" 

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 The Mead Consulting Group has helped dozens of clients prepare for successful sales transactions ranging from $15M to $350M in transaction value. We help companies increase the value of their businesses leading up to a transaction, minimize the things that cause potential buyers to discount the price, prepare to best position the company, and assist the owners in building a  transaction team.

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What successful business owners say about us:

 ...We could not have completed the sale of our business without the advice and guidance of The Mead Consulting Group. Their experience was critical in helping us prepare, and endure, the transaction process to a successful outcome

. ...Charles M, President, Healthcare IT Company

 

A successful process is draining and stressful.  The Mead Consulting Group brought the experience and expertise necessary to help our team focus on the critical issues and not get caught up in the multitude of items that can derail a transaction.  Why reinvent the wheel?  We chose to take advantage of individuals who could help us understand the nuances, negotiate effectively, and close the deal 

. ...  Ken W, CEO, Behavioral Healthcare

...We missed the opportunity to sell our family business during the last upcycle. Mead Consulting helped us grow revenue and EBITDA to record levels and guided us through the selection of a transaction team. Dave Mead and his group provided great counsel throughout the sales process, removing obstacles and firmly encouraging us to a great deal with a strategic buyer that mirrored our family business values.

...Dan M, President, Building Products Company

...I do not know why anyone would attempt to sell their business without Mead Consulting. Since they have owned and sold their own businesses, they understand the challenges of continuing to run the business while trying to sell it. Their experience kept us focused on the right things and they helped keep our transaction team well-aligned during the process. They truly act as the advocate for the CEO and owner, helping to make sure that it was the best deal for the owner. ...Ron T, CEO, Software Business

   

 Let us your your thoughts. Post your comments below.

The Value of Mentoring Youth

[Editor’s Note: As we enter the season of giving, I thought it might be appropriate to share an article about giving back. I have been concerned about the lack of role models and adult guidance for many of our youth and it has been demonstrated that youth who have a formal mentoring relationship do better in school, stay in school, have lower incidence of substance abuse, and lower incidence of crime, not to mention an overall better future. As I began to investigate the statistics about the value of mentoring, I found that the results are compelling. Mentoring benefits not only the individual and the community, but also employees and businesses.

Most successful people know the value of mentors – I know I have been fortunate to have had several key mentors over the course of my life and career.

One of the things my mother used to say: “If something concerns you, stop whining about it and do something to make it better.” Years ago, I was a Big Brother for several years and it was very rewarding. I wanted to have a bigger impact. So, I joined the Board of Mentor Colorado (Colorado Mentoring Partnership). In Colorado almost 300,000 young people do not have a formal mentoring relationship. Mentor Colorado (Colorado Mentoring Partnership) is the support organization for the 60+ mentoring organizations to help them in scaling their activities with adoption of best practices in recruiting, training, and supporting mentoring relationships. There are mentoring partnerships in 26 states. Mentor Colorado is one of the most recent states to form an organization. The models Colorado is following are the organizations in Minnesota, Massachusetts, New York, and Pennsylvania which have dramatically increased the number of quality mentoring relationships. – dpm]

In 2015, The National Mentoring Partnership and Ernst and Young sponsored a 2015 report Mentoring at the crossroads of education, business and community about the value of mentoring to the individuals, the community, and to businesses. As the report states it, “Mentoring is changing the trajectory of thousands of young people’s lives.” 

Value to the individual and community.  Some of the benefits to the individual and the community include:

• Better school performance.  Improved attendance,  higher graduation rates, and more likely to go on to college

• Less Substance Abuse. Mentored youth are less likely to start using illegal drugs and alcohol.

• Lower Crime rate. Fewer disciplinary problems and lower incidence of criminal behavior

• Better jobs and much less likely to be dependent on entitlement programs

Value to companies.  Key reasons companies engage in youth mentoring:

• Fostering employee engagement, satisfaction and retention. Today’s employees are strongly attracted to companies that are purpose-driven and that offer opportunities for engagement.

• Cultivating and developing their future workforce. Prepare a more productive workforce

• Supporting vibrant communities (which include viable customers) 

• Branding
• Improve its image in the community
• Increase community awareness of its mission

Mentor Colorado can help your company get started.

Many organizations have a fragmented approach to not-for-profit activities. Other companies may not know how to get started. Mentor Colorado is helping sponsoring companies with the development of mentoring programs, training, and managing mentoring activities.

Become a Founding Sponsor and make a lasting difference.

To get involved:  

If you would like more information about how you and your organization can get involved (and make a positive difference), please contact Dave Mead or Executive Director, Brad Strong.

 

Ten Deadly Sins of CEOs and Business Owners¹

[Editor's Note: Being the CEO or business owner can be a lonely job. It is important to get good feedback so that you can keep a balanced perspective. Below are just ten of the deadly sins that can be committed by the guy or gal at the top. I have been at the top or owner of eight companies - and I know it's not always easy to see yourself clearly. This is a reprint of a previous Issue for Growth. I think it still holds true. As always, we welcome your comments.  - DPM]

                                                                                                                                       

Talking Too Much. You never learn by talking, but some CEOs imagine the world to be in desperate need of their constant wisdom. It is a rare subordinate who will risk stifling a CEO. Be inquisitive, ask questions, and listen at least 75% of the time.

Goals Are Too Aggressive. It is wonderful to have a BHOG (Big Hairy Audacious Goal) or vision. It's another to develop overly aggressive goals on a routine basis. Unrealistic goals "demotivate," especially when compensation is involved. One CEO expected his company to continue its 30 percent annual growth rate, not appreciating that with a larger base and a rapidly maturing market their era of high growth in that market had to end. The result discouraged managers.

Personal Power Building is More Important than Value Building. Some CEOs tend to make decisions that enhance their scope and influence, even at the expense of increasing shareholder value. This can be paradoxically true even when the CEO is a large shareholder or the business owner. Dr Robert Kuhn puts it this way: "I want a CEO whose greed exceeds his ego. Good CEOs and business owners should be motivated more by amassing wealth for their shareholders rather than by building empires for themselves."

Not Respecting or Recognizing the Ideas of Others. CEOs and business owners can be egotistical. Highly successful almost by definition, many CEOs would seem to have every right to be self-impressed. However, when you hold the top spot, puffing yourself up at the expense of subordinates impedes the organization. You benefit when your people are encouraged and empowered to generate novel ideas. Recognition of these good ideas breeds more ideas.

Not Focusing on Accountability and Execution. Some CEOs and business owners love new ideas, programs, and initiatives. They introduce change for the sake of change. One company we looked at recently had seventeen (17) major strategies for an upcoming year. Focusing on a executing well on a few carefully selected strategies, developing clear objectives, and holding managers accountable, can be the difference to success.

Managing by Summaries.  A CEO should perceive the world as it truly is; if cluttered and chaotic, so be it. When information is always "high level," predigested by staffers, a CEO may perceive an artificial world, a virtual reality as it were, of cleanly manicured lawns. Most CEOs have great instincts about their businesses, and such instincts should be nourished by raw data, like, for example, call reports of customers.

Don't Fall in Love. When you sit in the corner office, follow your head not your heart. Every business must have a strategic or financial purpose, and if a business happens to make you feel good that's fine as long as your emotional attachment doesn't interfere with your rational decision-making. CEOs are notoriously vulnerable when making acquisitions.

Feeling Invincible.  CEOs must have superb track records-some are almost unblemished -so they have a proclivity to imagine themselves as invulnerable. The natural corollary is a robust confidence, even if subconscious, that past success assures future success. I can't tell you how many dozens of CEOs I've seen who refused to sell their companies at what would turn out to be, in hindsight, their peak market values, simply because they were convinced that tomorrow's prospects would mimic yesterday's triumphs. Looking backward and looking forward, a humble, healthy respect for the subtleties of serendipity is the beginning of wisdom.

Halo Hiring. In some organizations, many of the senior executives look like the CEO. I mean this quite literally and it can be very funny. Not just obvious characteristics like gender and race, but also personal traits like size and stature, political philosophy, sporting interests, demeanor, even style of dress. In a globalized world where customers and suppliers may be very different kinds of people, it is not wise for the executives of a company to be homogenous, and hence, uniform in their thinking.

Beware of Averages.  Averages can deceive. For example, assume that, in a pharmaceutical company, prices are declining for one-half of the drugs and increasing for the other half; the fact that the average price of all drugs has remained steady is worse than meaningless information. Strategies for drugs that kept prices steady might not work at all with those whose prices were decreasing or increasing. The same is true for net profitability on an individual customer basis. Averages hide meaningful information. The information extremes or "skew" is your friend.

¹Excerpted from 12 CEO Diseases and How to Treat Them, Dr. Robert Lawrence Kuhn, CEO Magazine, October/November. 

Why demographics may drive business owners to sell: Re-evaluating your transition and exit

[Editor's comment: Many business owners and CEOs have been delaying the process of preparing to sell... thinking that it is some point off in the distant future.  It has occurred to me that perhaps the actual best time to sell might be a lot closer than they think and may be more dependent on demographics than economics.  - DPM]

Have the markets for transitioning your business fundamentally changed? In the early 2000's there was a robust market for selling businesses.  The economy was strong, the market was flush with private equity, and the opportunities to grow businesses seemed endless. Then came the great recession of 2008 - 2012.  Was this recession a blip? Will we be soon returning to robust economic times over the next few years? Many will be hopeful leading up to the 2016 presidential election cycle. Regardless of your political leaning, there may be forces at work that neither candidate could overcome.

Demographics have a profound impact on business cycles. Twenty years ago, I attended a conference with the keynote address given by noted demographer, Harry Dent, who forecast several major economic cycles over the past several decades including the early 1980's and the current recession starting in late 2007. Dent's basic premise is that business cycles and opportunities are driven by demographic-based economics. Since 70% of the economy depends on consumer spending, he reasons, tracking consumer spending volume is a key driver. Spending habits, life decisions, etc. are driven by significant demographic changes. If you follow the bulge of baby boomers through the lifecycle, the last of the baby boomers reached age 50 in 2015 - a time in life that starts a decline in overall family spending.

See the graph below which shows peak U.S. family spending. While it shows a slight spike, coincidentally in the 2016 election year, Dent shows that the next decade will decline, bottoming in 2023.

Demographic spending patterns may indicate 8-10 more years of decline. Whether or not you believe Harry Dent's many other conclusions, it is interesting to note that in recent years economists have become focused on economic trends caused by demographic extremes. Declining birth rates and aging populations in Europe and Japan foretell long-term economic decline. Issues with a dramatic imbalance of males and females in China due to the 1-child rule (mostly male) are causing predictions of a serious aging population within the next 20-30 years, etc. The truth is, politics and policy aside, that the next decade could continue to be one of decline in the U.S. until the spending impact of the echo baby boomer generation (2024 -2050) takes effect.

Baby Boomer Business Transition Bubble.  The number of baby-boomers who own businesses who are at (or approaching) retirement age who need to sell to provide liquidity for retirement is at an all-time high. Consider this - in 2001 the number of business owners with businesses between 5 and 500 employees that needed to sell was 50,000. That number reached 350,000 by 2006 and 750,000 by 2008-10. There were relatively few sales in 2008-2012. Today, with that four year pent up supply of sellers, the number is estimated to be between 1.2 to 1.5 million.

What does all that mean to you, as a business owner? If you are in your forties or early fifties with many work years ahead of you, your business is performing well, and are in an industry with strong growth, you should focus on strategies that will help you continue to grow and expand. However,  if there is little growth in your industry, or if your industry depends on robust overall economic growth, perhaps now is the time to prepare to exit.  In these situations, it is possible that the value of your business may not be higher in 5-10 years - it may actually deteriorate.

If a business owner is in his/her mid-fifties to mid-sixties and the business has strong EBITDA over the past 12 months, consider planning to exit as soon as your company can be prepared. As we have outlined in other articles, it may take 12 -30 months to prepare and execute a sales transaction. Investment bankers, report that companies in this situation are commanding valuation multiples at near-record levels and are in high demand. So you could take some chips of the table.

Knowing when to harvest your business may be your most important decision  

If you would like to have a no-obligation conversation about building value in your business and evaluating the optimal path and timetable for a successful transition and/ or exit, please contact us at Mead Consulting Group. Our senior consultants have been involved with helping dozens of business owners maximize value as well as having the experience of previously navigating their own businesses through successful exits.  www.meadconsultinggroup.com