The Economic Outlook is Mixed but Optimistic
Near-term forecasting isn’t always that helpful.
Taylor Moore: Our economic projections are often wrong, so we really don't try to forecast near term changes in the economy. Instead, we focus on what we consider the fundamental drivers. The big things for us right now are the geopolitics of the world, the fracturing between the supply chain with Asia, the wealth disparity in the U.S. and the expansion of AI & automation.
Deals were on pause – but the deal pipeline is strengthening.
Brett Larson: The most significant dynamic affecting law firms has been consolidation, which is causing middle/lower market and Midwest companies to compete with coastal companies for legal services and pay higher rates when working with those firms that were independent and now part of a national firm. The biggest obstacle for our growth has been acquiring talent. Last year was a challenging year with lending really tightening up which put some deals on pause. But, we have more pipelined right now than we've had since probably 2019, which is saying something.
Baby Boomers are driving new opportunities.
Colin Johnson: We see more baby boomers wishing to transition their businesses than ever before. We think about a supply and demand curve for M&A with supply being business owners that need to sell. This is high right now. We are bullish on deals getting done, especially as the uncertainty fades.
Tight labor markets will require flexibility.
Kathy Hollenhorst: There has been a whole change in the labor force and there will continue to be a major fight for qualified labor, not only because of COVID but also due to the Gen Z emergence in the workforce. Flexibility is going to be required, in terms of work hours, work location, and pay expectations which have increased. It may be a good time to ‘transition out’ your C players but, more importantly, be sure to protect your A players as they are the first ones being sought out by other companies.
Consolidation is increasing competition, so clients are seeking more guidance.
Travis Bezella: We are a family office, and we are seeing small independent firms with just a handful of employees being consolidated. Our clients are not only seeking investment management guidance but also guidance for their estate planning. They need an entire team of experts that can guide them in all the areas to consider.
Valuation Will Vary but Doing Certain Things Will Increase Your Multiple
Forward-looking cash flows are key.
Colin: The biggest misconception about valuation is that while you are thinking about what the business is worth, the acquirer is buying your future cash flows. An acquirer does not get a dime of what you made historically so we emphasize forward-looking cash flows. Your historical results do give credibility for what you might do in the future, but a solid forward-looking strategic plan and a smart perspective on future cash flows is key.
Real value comes from the strength of the business.
Taylor: We typically invest in businesses between $50 and $500 million in revenue, and financial performance is the scorecard that a buyer uses to determine value. The real value of the business is driven by the appeal of the industry, the size of the competitive moat, and the real strength comes from the people running that business. If you are considering an exit, make a plan well in advance. If you plan to exit the business at sales, planning for your succession is a huge driver of value.
It's not the multiplier, it’s the number you are multiplying by.
Brett: A lot of people only focus on the multiplier when bragging about their deal; but really the number to focus is what you are multiplying BY. When we talk about multipliers, it usually in a range say from four to six or six to eight times EBITDA. As you get ready to sell, find out for your industry what attributes make an 8 versus a 6 multiple, as understanding those value drivers and detractors are important.
Talking to brokers can help you define your value.
Kathy: When we decided to sell and took Creatis to market, the process of searching for a broker alone was incredibly valuable. We interviewed three companies and learned what they felt the business was worth and, of course, how they could help us (we were given EBITDA ranges from them at 4X on the low end to 8X on the high side). Ultimately, we ended up being much more valuable to a strategic buyer because we had too much dependence on me (and I didn't want to continue operating) and we had a significant concentration in one large client. Neither of these were an issue for the strategic buyer because we were rolled up into their much larger company, but it was a significant problem for the financial buyers we spoke to.
Value comes from things set in motion way ahead of time.
Travis: One theme I am picking up is a lot of value comes from things set in motion years ahead of time. The right value is created by having a good succession plan, normalizing your financials, and preparing yourself accordingly. Defining how much you need from the sale is key. Spend the time now to decide what you are aiming to get out of the sale, not only for the business but also for you personally to achieve your goals.
Both formal and informal valuation Is important.
Colin: To piggyback on something Kathy said, we see people misconstrue that paying someone to do a formal evaluation study and having those meetings with the advisors are the same thing. Getting smart on what the business is worth is essential and both exercises are important to this. But they are very different exercises in terms of what the true market value is.
Scout’s honor: Be Prepared is a good motto and increases value.
Taylor: Preparing 3-4 years in advance can add a tremendous amount of value to your business. People often think of the basics, like bringing in a qualified estate and tax planning advisor. Perhaps more importantly, get advice on how a buyer will view the company, including both the strengths that can be enhanced and possible negatives, customer concentration or people dependency, which can be mitigated. For example, if you've demonstrated that you can do acquisitions within your company, even if they're small, that can really drive up the multiple the buyer is willing to pay.
Each Transaction Is Unique but Sophisticated Buyers Look for Common Things
Find a strong partnership dynamic and get hard issues out early.
Taylor: We look for businesses where the entrepreneur or family wants to be involved and really build that business to be a larger scale. This partnership dynamic is essential for all our investments. In many instances, the seller retains up to 40% or even majority ownership. Alignment up front is critical and it’s important to take on the hard issues and have hard conversations as early as possible.
Legal risks can blow up a deal so invest in compliance.
Brett: We have seen several things from a legal perspective that can completely blow up a deal even if the company is great from a financial perspective. We recommend an investment in compliance to ensure that from a legal perspective there are not any arguable issues that a buyer will use to drive down value. For example, we've seen underfunded pensions that were a big problem, but we got to it early and were able to deal with it. Try to de-risk your business and make sure that whatever skeletons you might have are discussed early. Standardizing customer contracts will reduce transaction risk and if done properly can speed up your sales process. Immigration and environmental compliance are potentially big issues and data security is something that a lot of middle market and lower middle market companies are behind in.
Filling a geographic territory or adding an industry vertical is a win.
Kathy: Our strategic buyer was a large national company with no presence in Minnesota, so we became their built-in office for them. Our client concentration was not a problem because they had a Strategic Account Group for enterprise clients but did not yet have a healthcare vertical, so we filled that void for them. And, because we had only a thin layer of management and I didn’t want to stay post a short transition period, they didn't have the burden of transitioning out a lot of our management which made it very easy for them.
Best hands for an asset – finding the best fit and value.
Colin: We look for the ‘best hands for an asset’, meaning finding the best fit and the best value. Some groups care about geography, and some don't; you can’t guess what each one is thinking so it’s important to canvas the market. Work a list of smart people to review that opportunity and get input about what they like about the company. Make sure you've vetted the things that will be important to a buyer as that can lead to a big discrepancy in what somebody's willing to pay for your business.
Best Tools & Practices A Seller Can Use to Increase Value and Interest
Be smart, get prepared and be kind.
Kathy: Three headlines: smarten yourself up, due diligence is pure hell so get prepared, and be kind to your 2IC's because you need them.
Smarten yourself up because the more you understand about the process and the market the better you will be in negotiating. Use your Allied Executives community and talk to people who have gone through a sale before. I’m a big fan of John Warrillow and his books called Built to Sell and The Art of Selling Your Business are a must read. I also highly recommend the Built to Sell podcast which covers stories about people who have sold their business with both great and horrible results.
Due diligence can be hell because you have to still run a profitable business AND do due diligence which are both full time jobs. Be sure to do Pre-Diligence which means get your house in order now both operationally and financially. Get a list from me or a broker to see the types of information you’ll need to produce in the due diligence process. And, during due diligence, get crystal clear on what data is needed and in what form. The data requests themselves don’t that kill you, but the iterations do. We eventually got smart and had the buyer’s team give us a templated report to use which we just populated with data to ensure we only did it once and they got what they needed.
Finally, be kind to your 2IC's - your second in commands – and those operating the business. Say thank you to them every day during this process. And, if possible, lock them in with some form of equity because even having a small ownership stake provides an even bigger incentive for them to stay engaged.
It's best to sell when you don’t have to.
Travis: From the personal side of things, it's always best to sell when you don't have to. As you're approaching this, look at the entire picture. What are you trying to achieve? Why even sell? Are you selling to, or transitioning to, your kids? And figure out what you are going to do with your time. I see many owners where the vast majority of their net worth is in this business and now, they have a pile of money. Many haven’t had to deal with a pile of money before, so partnering with somebody to decide what to do with it is vital.
It may be your legacy and identity, so get clear on your goals.
Taylor: A huge part of a business owner’s identity is wrapped up in the business so make sure you're clear on what you want to accomplish. If your goal is to maximize price, then that's easy. But if it is to continue your legacy through the business, then it’s about finding a partner that you can work with. Make sure you are clear on what you want and write it down. Once you get into the actual selling process, it becomes a game of who can pay the most for your business and I see people lose sight of the other things that are important to them. The difference between X amount of money and X + 5% doesn't impact the seller’s life, but not continuing their legacy certainly can.
Plan ahead and bring in number two and three who are aligned with your goals.
Brett: Planning ahead is very important. Really thinking about what is important to you other than headline price. That can help the bankers identify the right buyers, and you don’t necessarily have to take a discount to find the right buyer. We can use other competition to drive a higher price. Minimize the importance of the founder, try to bring in the number twos and threes and make sure they are aligned with your goals. This has always been important but non-competes were eliminated in Minnesota last year. Recently, the FTC released a ruling that said no more non-competes are allowed except for some high-level business executives. But there are other things that you can do like an incentive stock option plan, phantom stock plan or a bonus plan that can really align the leadership team. The earlier you start thinking about those things, the better.
First set your goals then surround yourself with smart people who can help.
Colin: How long the sale process takes is different for everybody. There's not a standard answer for that. But establish your goals first, as that will drive how the entire process is constructed. Build a team. Find people you trust across the different disciplines which includes an investment banker, a wealth management advisor and legal counsel. It’s very important that you've get an M&A attorney and some formal tax expertise. Also, the first thing to have in place is a solid strategic plan to credibly demonstrate the strength of the business and where it's going. Define your goal, build a team, and develop a strategic plan. If you do those things and have the right people around you, the likelihood of success in a very high.
There is such a thing as too much transparency.
Kathy: We used bonuses and incentives to retain our key leaders which included a deal closing bonus, particularly for my CFO, and quite large ‘retention bonuses’ for the leadership team that were ties to maintaining profitability and paid out after the earn-out period. One strong word of advice, even though you likely pride yourself on being fully transparent with your staff, there’s an art and science as to what you communicate to whom by when. I handled the due diligence independently for six months, then brought my CFO in and then a bit later the rest of the leadership team right before the management meetings. I encourage you NOT to communicate too early. Not everyone can appreciate the many years you spent building the business, taking no salary, and working round the clock. All they see now is that you are getting a ton of money and they’re doing all the work.
The Highest Bidder Doesn’t Always Win
Travis: Many times, business owners want to get the highest value possible. For those on the panel who see deals on a regular basis, what percentage of the deals do you see go to the highest bidder?
Colin: I’d say 5%. Most of my clients choose the buyer based on fit.
Travis: So, what that tells us is that your valuation, your discounted cash flow model, is important. But identifying the other pieces about your business that matter is probably even more important.
Brett: A good banker can help reduce the delta between the highest bidder and the one that you really want. Identifying what’s the most important to the seller and buyer up front is critical.
John Palen: The bottom line for all of us is continuing to be a good leader and business owner is that there is a finite set of best practices for selling: getting organized, communicating, planning, executing that plan, delivering the kind of results that are great. The better we get at figuring out how to handle our business day-to-day, regardless of when we want to transition out and sell, than the whole process becomes so much better and so much easier when that time does come.
The Typical Time It Takes to Prepare for and Sell Your Business
Brett: We do many deals a year on both the buy and sell side, and the timing varies greatly. It is dependent on the macroeconomic conditions, the micro condition of your company and your industry and what your timeline looks like personally. You may find you are not really ready to sell, or the business isn’t ready, and it might take two to three years to get there.
Kathy: It was 15 months from the time we made the decision to take Creatis to market to when we signed the deal. It was during the first year of COVID which complicated things and we did walk away from the deal with our strategic buyer about halfway through and had to re-engage, but it was fifteen months end to end.
The Importance of Culture When Selling Your Business
Cultural alignment has significant importance, especially for a strategic buyer.
Kathy: We were the second acquisition for the company, 24 Seven, that bought Creatis in 2021. They have now just completed their 8th acquisition and will continue to grow through acquisition. Culture is one of the top criteria they look for and every company they have purchased has very similar values and cultural fit.
Taylor: Culture is a huge factor for us as well. The biggest predictors of future success are how happy a company’s customers and employees are. We evaluate and measure both as part of the diligence process. We find it to be extremely revealing. I would say it is not common for the culture to be a true competitive advantage, but in today's environment where it is so hard to hold on to good people, it differentiates the winners and the losers in any industry.
Kathy: Culture was important in our deal because it was a strategic buyer, and the intention was to roll us up into the mothership. I think it might be less important for a financial buyer but because our strategic buyer was rolling us up, we needed to easily fit into their way of doing business.
Taylor: Culture is in the top two or three things that we're always looking at. Every company has its own distinct culture, and, in our case, we don’t try to change that culture. Part of our job is to work with the strengths and weaknesses of whatever that culture is. When selling to a strategic buyer, though, you will need a lot of compatibility as different organizations value different things.
The Considerations When Determining the Right Time to Sell
It’s a good time to sell, assuming the right things are in place.
Brett: Right now, is a very good time to sell as there is a lot of interest on the buy side that wasn't there last year, and valuations have stayed high. Interest rate changes haven't affected the transactions as much as just the tightening of lending as it's harder to get as big of a loan now. And, we’ve had to get a bit more creative in maximizing that value which might mean an earnout and some seller financing in the smaller deals with some pretty attractive interest rates. You need to get comfortable with the credit worthiness of the buyer, and de-risk the earn out itself by tying it to things like revenue or gross profit.
And the one thing that we haven’t talked about yet from an estate planning perspective is that federal exemptions for estate taxes are being cut in half, from about $26 million for a married couple down to about $13 million. It is going to happen unless another budget bill is passed. So, a lot of our clients are engaging in estate planning and some recapitalization of their companies.
Estate planning is essential - at least investigate the strategies available.
Travis: Speaking from the personal side, estate planning exemption is essential and various strategies can have significant implications. Think about voting versus non-voting rights and recapping the business. We have a lot of clients that are changing things to take advantage of these higher exemptions. It should create a sense of urgency to at least investigate the strategies that are available to maybe shelter some of your assets, especially your business.
Good financial results, changes to a key client and the need for new investment led to our sale.
Kathy: There were three things that triggered us to take Creatis to market. First, we had a nice 5-year trend of profitable financial growth. This 5-year look back was the basis for telling our story about why our future years could also be profitable. Second, there were changes happening in the large client that drove a majority of our volume that were starting to impact profitability of that account. That would have had a huge impact on us as a small company but wouldn’t matter at all to a strategic buyer who was so much larger. The final thing was that to get to our next stage of growth we needed to make significant investments in people and technology. We decided rather than us doing that, it was a good time to find a strategic buyer who could leverage systems, staff, and administrative processes already in place.
So You Think You May Want to Sell, Now What?
Start planning right now!
Travis: Take the time and start planning now! It takes years to make sure that you're getting the best valuation. Make sure that you have a team around you and know it might not be the professionals that are in your life today. Start that process and develop those relationships because you want a good team to help you guide through the sale process.
Don’t get scorched by due diligence hell.
Kathy: Do not underestimate the hell that is called due diligence and get prepared. Start getting your house in order now as it will make the due diligence process much easier when the time comes. And on behalf of second in commands everywhere, know we're extremely grateful that we get an opportunity to stand by your side and help grow your business. But likely we are not wired the way you are, and we don't necessarily think the way you do. As you are going through your selling process, remember to be kind to your 2ICs as the process is a difficult one for them as well.
Be sure to make the smart, right decision.
Colin: Not selling is also a decision. Having the discussions we’ve been talking about like doing the process of evaluating brokers can help expand your knowledge. Even if it doesn’t make sense to sell, you'll be smart on how you can grow your business and put a plan together for when you do. And a good advisor will not have a bias in the process, but they can help you to make smart decisions.
Identify specific goals and reduce due diligence pain by preparing now.
Brett: The adage is if you're not a seller, you're a buyer. Just start planning and meet with somebody like Colin because it makes you a lot smarter and help you identify specific goals that are going to drive value. And the only way to avoid due diligence being a complete - you know – what Kathy said – is to get ahead of it. There are a lot of things that you can do to make that process not as difficult as standardize contracts, standardize employment agreements, standardize your customer terms and conditions - things like that. We know what the buyers are going to need and if you can do it over a period of time, it's not nearly as painful.
Bring in outsiders to help you evaluate things objectively.
Taylor: The concept of bringing in somebody from the outside is extremely important. Find someone that can objectively look at the things you would do to build the value of your business and really give you feedback at a deep level. They can look underneath the hood to understand your business and give you objective feedback. That’s extremely valuable.
Just run a great business which delivers value to customers, employees, and yourself.
John Palen: I think the important message here that as business owners we need to identify the best way we can lead, plan, execute and deliver to our customers, our employees and ourselves the kind of ROI we want and deserve. The better we figure out how to do that every day of the normal operating of our business, the better we'll be prepared when we do want to sell.
