By Arlin Sorensen, O and Founder of the Heartland Companies which includes HTG Peer Groups
One of the areas I spend considerable time on is helping business owners prepare for and then complete an exit from the business they often founded and have worked in for decades. Let’s get one thing straight: It is a big deal for an entrepreneurial owner to exit his or her business. In fact, it is a very big deal. The saddest call I receive comes from a small business owner that has worked in their company for decades. It was their creation, and they have poured sweat and blood into building it to where it is today. The call usually goes something like this:
Owner: I’ve been trying to sell my company for a while now. I talk to brokers and they tell me it isn’t worth much. That can’t be true. It’s my retirement. I’ve poured my life into it working from sunrise ‘til sunset for decades. It has to be worth something!
My response: I’m not in the transaction business but will be glad to take a look at your financials and provide some consulting advice around what I see there. Please send the last three years’ P&Ls and your balance sheet.
Owner: I’ll need to explain the numbers to you. They aren’t nearly as bad as they look. [Picture me smiling here.]
I’ve had this happen dozens and dozens of times just in the last year, let alone the past dozen years I’ve done consulting work. The fact that they have to explain their numbers is always true, because most small business’ financials are a mess and make no sense. One of the first things that jump off the page when I look at a typical set of financials is how little equity is in the company. In fact, a high percentage have negative equity showing. Based on that number alone, you need to pay someone to take your company off your hands. People don’t spend money to acquire a company that is going backward. The balance sheet matters, and it needs to not only be managed, but made strong if you have any intention of EVER selling or merging your company.
Then comes the P&L. It typically shows little to no income, which helps explain a negative balance sheet since they are connected. But, of course, the P&L isn’t accurate. They have manipulated it by driving income down so they don’t have to pay taxes. The reality is that companies that don’t make money aren’t in high demand, so driving the P&L towards zero is a very bad strategy if you want to maximize valuation. Sure, you can attempt to do add backs and deducts based on your story of what you’ve done, but buyers are leery of that practice. It is far better to run the business for the purpose it was created — to generate a profit and provide jobs — than spend all the time necessary to try and manage a P&L toward zero and then have to sell the story of why you should get credit on your P&L when you want to sell for your years of creative money management.
Next the discussion moves to how much the owners are paying themselves. On rare occasions they are paying above market rates, but usually they are not paying much and in some cases nothing at all. They take their salary as distributions if the company makes any money, which is counter to their tax management strategy; and they end the year with little or no direct dollars to live on which makes life at home a joyful experience. If you are running a real business, you need to treat yourself as an employee and put yourself on the payroll. It’s necessary for benefits anyway and certainly gives the business far more credibility when it’s time to sell.
There are often personal items that owners try and expense through the business. Planes, trains and automobiles are the most common. Well, maybe not so much on the trains part, but they find other things to spend money on like homes or vacations. Sometimes there are family members on the payroll who really aren’t contributing much, or at all, but they need benefits or some money to live on. I realize you run a business to have the benefits of ownership. But there has to be some sanity between enjoying the current benefits of ownership and making choices today, realizing that you will want to exit sometime in the future.
One thing to keep in mind: The more convoluted the finances are today, the more complex the sale will be tomorrow.
If I sound like an expert on these things, let’s just say I was guilty of most of these and a lot more during my time leading an IT company. It wasn’t until I wanted a loan to do my first M&A transaction that my banker sat me down and candidly shared two hard truths with me. He spoke them with authority and some passion:
- Banks don’t loan money to companies or people who don’t appear able to pay it back.
- If you want to grow your company, you have to make money and build a strong balance sheet.
Then he laid this principle on me: CASH IS KING! Not sometimes, but always.
To say he refused my loan request was an understatement, and I learned then and there that some major changes were needed if I wanted to take SCCI to the next level. I had to grow up as a business and an owner and create a company with a regular profit and a strong balance sheet. You want to maximize your company value? Make money consistently year after year and build your balance sheet. That’s the kind of organization people line up to acquire.
Financial preparation is the first area to consider when planning a business exit strategy. It isn’t something you can repair or change overnight. It takes a few years minimum to change and can take longer in many situations. Most valuations are based on some form of a multiple of profitability along with the balance sheet. So you have to get ready financially if you want to position yourself for the best offer.
In the next post, I’ll talk about other things that need to happen if you want to plan your exit strategy to maximize your value.
Read Part 2
Arlin Sorensen serves as the CEO and Founder of the Heartland Companies which includes HTG Peer Groups. When he is not traveling to speak and consult, he is home on his farm in Iowa with his wife Nancy. He is a proud “Pop” to four precocious grandchildren who serve as daily reminders of why he is intentionally living to leave a strong legacy of faith and integrity. He loves making a difference in the lives and businesses of small business owners. You can reach him at firstname.lastname@example.org or on Twitter @asorensen.