Why Metrics Matter
Many business owners wonder why buyers insist on reviewing operating data as a part of their due diligence efforts. They protest that the metrics are immaterial, because their effects are already baked into the financial statements, which the buyers have analyzed ad nauseam. Sellers are usually comfortable providing the more administrative due diligence items, such as contracts and the tax returns, but struggle to understand why they should supply data on their companies’ operating activities.
Key Performance Indicators
Isn’t it true that the financial statements incorporate the impact of the operating metrics? If so, why are the key performance indicators critical to the buyer’s analysis? These “KPI” are important, because their trends can be the best indication of a company’s future prospects, and because they are the main inputs for calculating synergies (strategic buyers) and validating investment theses (financial buyers).
A simple example involves a manufacturing company that is performing well financially, but has seen its quoting activity fall significantly in recent months. Everything else equal, it would be logical to assume that the company will post reduced revenue and profits in the near future, but this potentiality would not be evident in the financial statements.
Another basic example relates to this same company’s scrap rates, changeover times and raw material prices. For buyers who either have similar operations or are familiar with industry benchmarks, these KPI indicate whether there is an opportunity for improvement, which, for strategic buyers, could also apply to their existing businesses. In addition, these data are integral to calculating, for instance, the benefits of facility specializations and rationalizations.
What If The Data Do Not Exist?
The smaller the business, the more likely the owners do not track all the information that sophisticated buyers want to review. But this issue may lead to even more exaggerated problems with novice buyers who, lacking experience, are unable to prioritize their due diligence needs and end up asking for everything.
We have encountered many business owners who managed their companies with an intuitive feel and had no way of producing historical operating data. In these cases, it may be necessary to reduce risk by lowering purchase price, increasing the amount of seller financing or seeking more robust representations and warranties.
In most cases, however, there is usually a way to create a time series of information about a very short list of the most important metrics. As a result, we recommend that buyers focus on the KPI that are critical to their analyses and then work with the owners to develop actual or proxy data for these fundamental items. If possible, sellers would benefit from spending time in advance of taking their companies to market in order to generate basic KPI data.
If you are aware of business owners who would like to sell their companies, but lack straightforward operating data, please consider introducing them to Bootstrap Capital. We have dealt with these due diligence issues as both sellers of the businesses we built and as buyers of other entrepreneurs’ companies. As a result, we are keenly in tune with the issues business leaders face when they decide to sell their companies, as well as many other nuances of transacting in the lower middle market. In situations where a business owner is working through these issues, Bootstrap Capital is, at a minimum, a patient counterparty and, even better, frequently a constructive partner in helping him or her through the process.
To Invest or Not To Invest
When business owners decide to sell their companies, they frequently have questions about how much they should continue to invest in their businesses. Just as homeowners must decide, for instance, on whether to upgrade the kitchen before putting the house on the market, business owners face myriad decisions about short and long-term investments in systems, personnel, equipment and R&D.
What Makes it so Difficult?
One of the reasons that sellers struggle with investment decisions is that the answers depend on more variables than usual, some of which are knowable only to the potential buyers. As a result, rules of thumb are hard to come by.
Whether to invest in a new machine depends on whether it is critical to a new piece of business, how profitable that new business could be, how integral it is to the company’s growth story, and whether potential buyers would relocate the machine or need it at all.
The analysis is just as complicated for the decision to hire new salespeople, create a new marketing campaign, upgrade a website or commission a new site survey. In all of these decisions, business leaders must weigh the impact of the investment on cash flow, current and future profitability and the company’s future growth rate.
Over time, depending on market conditions, the strategic needs of potential buyers and the historical performance of the company, the importance of each of metric to a sale process could change dramatically.
There is one exercise that we can recommend. Most business owners can list the investments that would have the biggest impact on the value of their companies in 2 to 3 years. We recommend that owners try to picture the sale process falling apart after months and months of negotiations and think about the investments on that list which they would most regret having postponed. Going through this exercise usually brings the highest priority investments into focus.
On a related note, our experience is that business owners sometimes have trouble seeing the value of a good M&A advisor. In addition to the more obvious benefits, such as creating an auction dynamic, a good agent can provide well-informed advice about how the market is likely to perceive a whole host of activities, including making specific investments in the business.
The principals of Bootstrap Capital principals have sold their own companies and dealt with these investment decisions during their own sale processes. As a result, we are keenly in tune with the issues business leaders face when they decide to sell their companies, as well as many other nuances of transacting in the lower middle market. In situations where a business owner is working through these issues, Bootstrap Capital is, at a minimum, a patient counterparty and, even better, frequently a constructive partner in helping him or her through the process.
Succession Planning is So Personal
Business owners put off succession planning for a number of reasons. It is hard work that takes time away from the day-to-day operations. Hiring professional advisors to assist with the process is expensive. It disrupts the status quo and creates risk for the business. And many owners honestly (and in most cases, legitimately) believe that, if push comes to shove, they will simply sell their companies.
But a less obvious reason is that the process isn’t just business. It’s personal… or at least it feels that way.
Why So Emotional?
At the core of succession planning is an emotional paradox that forces business owners to make difficult choices and betray their instincts. In overly simplistic terms, the more successful the successor becomes, the more inadequate the business owner might feel. The more the successor builds the founder’s legacy, the worse the founder is likely to feel about it.
Adding insult to injury, the more that departing leaders suppress their instincts to take charge and instead give their successors enough autonomy to properly establish their own authority, the more intense these feelings can become. And when success is coupled with substantive change (or worse, because of it), the owner can start to feel downright inferior. Even when the changes are due to relatively benign generational or stylistic differences, they can feel like direct criticisms.
So Why Do It?
It is therefore no wonder that so many entrepreneurs perpetually procrastinate when it comes to this time consuming, expensive, risky, potentially unnecessary and definitely emotional process. But for those owners who can detach themselves from the process and view the succession itself as a product of their own design, the rewards (both financial and personal) can be significant.
There are few wealth creation opportunities that compare favorably to ownership in a smoothly running private business. And when the founder can see the successor’s success, no matter how achieved, as yet another one of his/her own successes, the personal fulfillment can be tough to match.
Due to the numerous business and personal impediments to succession planning, we recommend that business owners engage a professional advisor who is familiar with the emotional aspects of the process to guide them through it. Hiring advisors who focus too heavily on the sanitized analytics or basic mechanics to the detriment of the softer issues adds unnecessary risk to an inherently difficult task.
If you have clients who cannot bring themselves to take on the emotional task of succession planning, please consider introducing them to Bootstrap Capital. Our approach is to provide turnkey succession plans by personally managing our portfolio companies. We have extensive experience as business founders, owners and leaders, which we bring to each and every one of our portfolio companies. In short, we provide the liquidity and leadership that business owners who lack a succession plan need in order to retire.
The “Chase a Buck” Syndrome
Many business owners constantly see opportunities to make money and do not hesitate to take advantage of them. One of the great benefits of owning a business is the insight it reveals about what is working well and not-so-well in an industry and how to profit from the issues that develop from time to time. But sometimes entrepreneurs see almost too much opportunity and make money too many ways.
What’s Wrong with Making Money?
In the abstract, there is absolutely nothing wrong with making money. But if an entrepreneur pursues too many disparate opportunities by “chasing a buck” rather than strategically investing in the business, the resulting company can be difficult for buyers to understand, command a lower valuation multiple or become altogether unattractive.
One example involves a company that was founded decades ago as a direct-mail advertising agency. In response to changes in the industry and to newer technologies, the company had evolved into a provider of turnkey promotional programs for salesforces, offering everything from conceptual design to ERP interface, performance tracking and prize/product fulfillment.
Along the way, the company added its own call center and began providing outsourced customer service to its best clients. And over time, instead of investing in the higher value elements of the business, such as the ERP interfaces and the program management software, the owner fell victim to the “chase a buck” syndrome and began to funnel most of the free cash flow into the call center. His rationale was that it provided attractive cash-on-cash returns.
By the time the owner was ready to sell, the call center was as large as the promotional program business and had a material influence on the overall value of the business. At the time, the EBITDA multiple for call centers had fallen to 3x, while the multiple for the ERP integration business was closer to 10x. However, buyers had a difficult time looking past the call center and the owner struggled to get bids north of 5x EBITDA.
Keep an Eye on the Exit
When they are allocating capital and setting objectives for their companies, entrepreneurs and family business owners should fight the urge to “chase a buck” and instead take into account the impact their decisions are having on the valuation multiple buyers might ascribe to the business. We recommend this practice even when the intention is to hold the business forever. It usually leads to faster value creation and provides better options in the event that circumstances change.
Investment bankers, M&A advisors and private equity investors are great sources of information on these issues. While there is some risk that they will do more than simply share their opinions, our experience is that, in the interest of establishing a relationship and positioning themselves for a future opportunity, most of them will be patient, act in a professional manner and resist the temptation to start a de facto sales process.
If you have clients who could benefit from a point of view about how a buyer might view their businesses or how certain strategic initiatives might impact the attractiveness of the business to potential buyers, please consider introducing them to Bootstrap Capital. Because we invest our own capital, we are not subject to the pressures of a fund’s investment timeline and are happy to share our insights without any expectations about an immediate investment opportunity.
Successful business owners sometimes “collect” assets in their businesses. When a company is producing surplus cash flow, there is little pressure to lower inventory levels or to dispose of old machinery. These assets can be “nice to have” insofar as they are occasionally useful in fulfilling customer requests, but they are usually unproductive and they almost never produce enough incremental cash flow to justify continuing to carry them.
Our experience is that nice-to-have assets are particularly common in the machining industry and consumer goods and other sectors of the economy where returns and consigned inventory are more prevalent. But we have seen this issue in virtually every type of business.
What’s the Harm?
However, since a buyer might be able to put these assets to work or potentially just sell them to recoup some of the original purchase price, don’t these semi-surplus assets just make a business more attractive to potential buyers? In fact, the opposite is usually the case. There are two basic issues which can make it difficult to get a deal done when the balance sheet is full of assets that are really just nice to have.
The first issue is related to asset productivity or the amount of capital a business requires to produce cash flow. When a business carries excess assets, it can be difficult for a buyer to determine just what assets are truly superfluous and how much cash flow is either directly or indirectly related to each of the assets that are only marginally utilized. It may be impossible for buyers to know which assets they could sell, how much capital expenditure would be required to grow and how much the cash flow could be impacted if they sold a few assets.
The second issue relates to the expectations of the sellers. It is our experience that most business owners who collect nice-to-have assets do so because they ascribe more value to them than they really have. That perception tends to produce an expectation that a buyer will pay a full multiple for the cash flow plus market value for the underutilized assets. The business owner’s argument usually centers around all the things the buyer could potentially do with the assets, despite the owner himself never having been successful doing those exact things.
What to do?
Our recommendation is that potential sellers who have a number of un- or underutilized assets should work with an M&A advisor or an operational consultant to sell those assets which are non-critical and to outsource what little work they were doing. If the extra assets are raw materials or finished goods inventory, the owner should systematically sell off the unproductive inventory well in advance of a sale so that a buyer can gauge the performance of the business without the support of the unproductive inventory.
The result will be not only an immediate influx of cash, but also a more understandable business with better financial metrics that, consequently, is more readily sellable.
If you know of business owners who have waited too long or are fundamentally unwilling to eliminate the extra assets they are carrying on their balance sheets, but are still interested in selling their companies, please consider introducing them to Bootstrap Capital. We can structure our due diligence to understand the productivity of a company’s assets and are willing to craft a transaction that enables a business owner to recoup the latent value in some of his/her nice-to-have assets.
It is common for business owners who are thinking about retiring or selling their businesses to consider establishing an ESOP. The allure of the tax savings that can result from a sale to an ESOP seems particularly strong to business owners who have owned their companies for a long time and are facing significant capital gains tax exposure. Add in the evidence that employee-owned companies perform better than their counterparts, and an ESOP becomes an intriguing option.
What’s the Catch?
There are reasons, however, why approximately 70 entrepreneurs and family business owners sell their companies outright for every single net new ESOP formation. Selling to an ESOP might actually cost more in professional services fees than an owner would incur in a simple sale, because the costs of both seller and buyer (the ESOP) are born by the company. And then there are the ongoing administrative costs for such things as the annual valuation and the ESOP trustee.
There are other costs, too, if the owners choose to implement an ESOP in what we believe is the “right” way. We have seen ESOPs that have worked unbelievably well and others that have failed miserably. While there are many factors that influence an ESOP’s effectiveness, one of the most powerful is the company’s culture and the relationship between the owners and the rank and file employees.
In the situations where the ESOP worked well, almost without exception, the owners showed a genuine sense of gratitude for the employees and believed that the ESOP was as much a way to reward them as it was to achieve liquidity.
Our observation is that, in these situations, the owners naturally take the time to educate the employees about the business and its basic financial results, as well as how their day-to-day efforts affect the company’s share price. Doing so can require a daunting investment of time and resources, but our opinion is that it is a crucial step in getting the employees to really act like owners and to to realize the associated jump in performance.
To the contrary, when the owners view the ESOP as something akin to a necessary evil that stands between them and their tax savings, things tend to break down. When the owners do not embrace open communication and instead limit themselves to the statutory minimum amount of disclosure, the employee-owners can actually become more suspicious of management than they otherwise would have been. And should the company hit a rough patch, particularly one that causes the annual valuation to decline, the employees’ willingness to go the extra mile might disappear just when the company needs it the most, triggering a damaging and self-perpetuating downward cycle.
In certain situations, we strongly believe that an ESOP is a logical and effective way for entrepreneurs and family business owners to monetize the value they have created. In other cases, due to a need for more immediate liquidity or a cultural mismatch, for instance, an outright sale usually makes the most sense. In these situations, please consider introducing your clients to Bootstrap Capital. We are seeking opportunities to provide liquidity to small business owners and to honor their legacies by investing in and growing the companies they have founded, nurtured and developed.
Many entrepreneurs understand that, in order to maximize the value of their businesses, they will have to become nearly expendable. But even if they are able to build an organization that thrives without their constant attention, they may not appreciate that their work must continue until every employee is as unimportant and interchangeable as possible. Some owners may even exacerbate the problem by transferring their own responsibilities to only a few key employees in the name of succession planning.
When we evaluate a business, we try to determine how much of its value is “institutionalized.” Much of the analysis is calculating how much a few key employees contribute to the company’s overall performance. But a secondary analysis evolves around how well the company has systematized its activities and how well it records and accesses information. In other words, we evaluate the extent to which the company’s processes and systems will help a new hire get up to speed and replicate a departed employee’s performance.
Similarly, one of the ways we improve our portfolio companies is to institutionalize their value by, for instance, developing processes, fostering collaboration and, when possible, adding redundant expertise. We lower the risk that the company could become dependent on the so-called “tribal knowledge” of a small number of indispensable employees and increase the likelihood that we can replace even our highest performing people.
Addressing the Problem
We routinely find businesses with one sales person who delivers a grossly outsized share of the revenue or a key engineer who is the only person capable of designing client solutions or driving the new product development efforts. In small companies, this key employee risk may be unavoidable, as it can require unattainable scale and resources to address properly.
In these cases, there are a handful of ways that owners can mitigate the risk and begin institutionalizing the value of their companies. Some tactics lower the risk that key employees will leave, while others reduce the impact in the event that they do so anyway.
The best way to keep the key employees is to increase their incentives to stay. Common approaches include (i) having the employee purchase equity – either directly or in exchange for a reduction in cash compensation or (ii) making an equity or deferred compensation grant that vests over several years.
Combining equity ownership with relatively punitive repurchase rights if, for instance, an employee departs prematurely can provide a powerful incentive for an employee to stay, as well as a mitigating increase in value per share for the remaining equity holders, if the incentive is not powerful enough.
Bootstrap Capital can work with owners to share the risk associated with employee retention and other issues that result from a failure to institutionalize their company’s value. If you have clients who would like to sell their businesses but are worried about how a buyer will view their own importance or that of a few key employees, please consider introducing them to Bootstrap Capital. We are willing to be creative in structuring a transaction that could allow them ultimately to get more for their companies.
When a business has just a few customers, it usually means that it has great relationships with them. There is usually a strong personal relationship that cements the business dealings, both of which may date back many years, or even decades. As a result, the owners are confident that their customer relationships are durable and will last long into the future.
So What’s the Big Deal?
It is our experience, however, that business owners tend to overestimate the permanence of these relationships and underestimate the risk that their customers could leave them for the competition.
For starters, as business owners age, so too do their counterparts. Few are fully prepared for the day when their contacts and friends start retiring and leaving their responsibilities to a younger generation of employees who may not be such loyal customers.
Fewer still have a contingency plan for the possibility that their primary customer could be acquired by a company that has historically done business with their competitors.
And even fewer have an adequate answer for customers who ask them to share their succession plans. An increasing number of sophisticated businesses include a discussion about succession planning in their periodic account reviews with key entrepreneur-owned suppliers.
For some business owners, this line of questioning may be the first indication that their relationships are more vulnerable than they thought and that customer concentration could be more than a theoretical risk that academics have cooked up.
The Buyer’s Perspective
Other entrepreneurs are not lucky enough to get this kind of wakeup call, and see the ramifications of customer concentration only when they try to sell their businesses. Buyers know that transactions can be disruptive to a business and that a change of ownership alone can be enough to cause customers to evaluate their reliance on a company.
Therefore, when a small number of customers account for large percentage of revenue, buyers lower the price they pay in order to account for the additional risk they are assuming.
The only foolproof remedy is to increase sales to a larger base of customers, but this is often unfeasible or even impossible. In those cases, owners can partially address the issue by utilizing long-term contracts. But this approach is imperfect, because no contract is bulletproof, the cost of enforcement can be prohibitive (in terms of actual cost or reputational damage) and, in order to coerce a customer into entering such a contract, a supplier may have to make material concessions on pricing or other terms.
The principals of Bootstrap Capital understand that, in order to have customer concentration, a company must first deliver value and demonstrate the type of responsiveness upon which great relationships are built.
Consequently, we are willing to structure acquisitions in a way that allows sellers to participate in, and reap the reward from, a well executed post-transaction customer retention plan. The end result can be a fulsome purchase price.
If you have business owning clients who would like to sell, but are concerned about how buyers will react to their reliance on a small number of important customers, please consider introducing them to Bootstrap Capital. We can be constructive and creative in dealing with this common issue.
Many business owners believe that their kids are as passionate about their businesses as they are. In some cases, the children may have actually told them as much. So, they assume that their kids will someday take over running the company.
Our experience is that few of these owners adequately communicate their expectations and test their children’s understanding of what their responsibilities would be. Others don’t realize that the kids are just telling them what they want to hear. The result can be a disorganized or inopportune sale of the company when it finally becomes clear that a family succession is not possible.
Clearly, running or even working in a family business isn’t for everyone. But many owners inadvertently stack the decks against themselves. Owners who engage their kids only to help solve the problems in the business, may inadvertently leave the kids with a lopsidedly negative view of the business. And those who don’t engage their kids at all, perhaps in an attempt to shield them from the stresses of entrepreneurship, miss an opportunity to pique their kids’ interest in the business.
Even in small businesses still run by the founding entrepreneur, succession from one generation to the next must be planned and executed over many years. Owners need to help their children develop a broad array of skills, expose them to multiple functional areas, test their ambition and leadership capabilities and teach them to be appropriate risk takers. Owners who engage their kids during this preparation phase, even if this happens when they are employed outside the family business, will know long before a crisis develops whether their kids will be capable stewards of the companies they built.
However, even when an owner is doing almost everything right, there can still be surprises. After all, as long as the founder is still available to answer questions and is taking an active interest in the business, it is impossible to simulate a complete succession. And when it is obvious that an owner’s dream is for his/her child to take over running the business, it can be difficult for the kid to offer a competing point of view and risk disappointing his parent.
Other times the owners ignore even the most obvious signs. We have known owners who thought they were communicating effectively with their children and were correctly gauging them as ambitious future leaders, but who failed to recognize that the children were never the first ones into the parking lot in the morning or the last ones out at night.
Consequently, it is important for business owners to work with an experienced third party who can objectively review the succession plan and evaluate the children’s desires and capabilities to run the family enterprise.
When a family succession is suddenly not an option and the decision is to sell the company, Bootstrap Capital can help make the transition more palatable.
For starters, we are comfortable with the sellers rolling over a significant amount of equity so that, for instance, they do not have to completely exit an attractive investment just because of a succession timing issue.
We are also comfortable having family members remain in the business and to continue their professional development. We understand that the non-standard career tracks in family businesses can make finding employment elsewhere challenging. And we also value the unique perspectives about the business that family members can provide.
Over the years, we have worked with many advisors and investors who suffered from the Only Affliction. Whey they saw a buisiness that was producing anything less than a few hundred million in revenue, they would report to their partners that the company does “only $x million in sales.” Many of these people had never done anything entrepreneurial and most had never run a company. They had no idea how difficult it is to achieve even $1 million in revenue. They had no idea how much risk, how many odd tasks, how much ingenuity, how many sleepless nights it takes to get a business off the ground.
Trained to be Negative
Once an entrepreneur has done all the hard work to build a business, it is tempting to criticize the final product. Consultants are trained to find and fix problems. Private equity professionals are trained to look for ways to improve the businesses they are buying. And investment bankers are trained to anticipate all the objections potential buyers could make about the companies they are taking to market.
So often this training develops into an impulse to focus on the negative. They see businesses as having “only” so much revenue, “only” so many customers, “only” so many products in the pipeline, “only” a couple great engineers. Compounding the issue is that few of the professionals suffering from the Only Affliction have ever tried to grow a company, let alone build one from scratch. As such, they have little appreciation for the intensity of the effort required to create a profitable enterprise.
The principals of Bootstrap Capital have founded and run several businesses and appreciate all the skill and instinct that are necessary to build a business of any size, to employ and lead people and to deal with the myriad issues that pop up every day.
We don’t see businesses that are “only” so big. We see the achievements of the entrepreneurs who launched the companies. We respect the legacies they built and we seek to continue the great work they started.
Our experience is that these heritages are valuable assets of the companies we acquire. When we preserve and celebrate the cultures and histories of our portfolio companies, we are not just honoring the entrepreneurs and families from whom we purchased them. We are also protecting our investment. When we preserve the legacies of these businesses, we give purpose to our mission and get dividends in the form of employee focus and loyalty.
People suffering from the Only Affliction have difficulty seeing these benefits and instead focus on all the perceived shortcomings in these great companies.
When a business owner is seeking a true steward for his/her business, Bootstrap Capital can provide a great solution. A key factor in the path we set for our portfolio companies is the impact it will have on their cultures and the people who built them. Change is a fact of life, but it is important to us that it not unnecessarily impact the heritage, values and people that are key to a company’s success.