Isolated Information May Equal Trouble

Some recent events have reinforced my belief that singular information can easily lead to the wrong conclusion. We see this in the news. A police officer makes a mistake, and some assume all cops are bad. A protestor (or protest hijacker) throws something, and some assume the whole group is bad.

Singular information in other parts of life can also get us off track.

I was looking at some of a client’s financial reports. Revenue and production efficiency should move together. If efficiency goes up so should revenue, and vice versa. But they didn’t; Efficiency was solid, but revenue went down. I found out the reason for this, it made sense but at the same time didn’t make sense. In other words, I now understand why it happened, but production efficiency shouldn’t be calculated the way it is/was. If all I did was look at one or the other, I’d get an incomplete picture.

The same goes for COVID cases. We are constantly barraged with the numbers of new cases. Just paying attention to the top line number can get you worried (it sure has with Washington’s governor). But if you look at the positive cases in relationship to the number of tests, you’ll see the numbers are up because testing is up. As per the Washington Department of Health’s website last week, the percentage of positive tests is (was then) at about half of what it was in April. Want to see the positive numbers go down, test less (that’s a joke).

Take this into account when you look at any business whether it’s to buy it, work there, or offer advice. It’s like peeling an onion. You peel until you get the right answer, whether it’s the one you want or the opposite. When it comes to buy-sell deals, you’re going to see a lot peeling. If sellers thought there used to be a lot of questions, they’ll now find their “onion” just got a got larger.

“Not all those who wander are lost.” J.R.R. Tolkien

All You Need to Know About COVID Era Banking

From June 4-10 Jessica and I interviewed bankers representing eight Puget Sound area banks.* This memo is a synopsis of those conversations about what’s going on in banking during the COVID crisis, with a focus on business acquisition loans.

If you want the full report, click here to get it. It’s in table format so you can easily see what each banker said on the various topics.

First, all the banks are, “Open for business” meaning they are considering making loans. What’s changed is underwriting is going to take longer and will be more thorough (my comment – underwriting wasn’t sloppy before COVID, especially compared to the years leading up to the Great Recession). COVID will be a focus of all analysis and underwriting, where the business was pre-COVID, how it was affected, what the future looks like.

Year-to-date monthly statements are extremely important. The banks recognize there are a lot of unknowns and realize we all fear the unknown to varying degrees. Projections will be scrutinized more than ever and owners and buyers who can present thoughtful projections, answer questions realistically, and not gloss over the current situation will be in a more favorable position. 

My accounting and CFO friends will like the following: the quality of the financial statements has never been more important. Some banks will look at the accounting department, ask if there’s a CFO or controller, and use that in their decision-making process. Having the owner’s sister-in-law who’s really a data-entry person but called the controller won’t cut it.

And, no surprise, there will be more sensitivity analyses and stress tests. Mentioned a few times was the figure “30%,” as in, what will the business, its cash flow, and debt coverage look like if revenue goes down 30%. As part of this, banks that previously did more conventional loans will now be looking to use the SBA 7A program (for its guarantees to the bank).

Consistently mentioned was how important relationship is (the PPP showed this) as well as how borrowers with known and quality advisors will be looked upon more favorably. It was said the source of the referral matters and if advisors are involved it’s a big plus. A few people encouraged borrowers to talk to multiple banks, find the right fit, talk holistically about how banking works, and have thoughtful questions and answers. Especially in regard to how the business is handling the COVID stress.

* Bankers who helped us

  • Banner Bank – Lynell Smith & Jacque Coyan
  • Columbia Bank – Jeff Wilcox
  • Heritage Bank – Addie Roberge
  • Key Bank – Jane Pekasky & Jennifer Ringenbach 
  • Live Oak Bank – Lisa Forrest
  • NW Bank – Gary Strand
  • Sound Credit Union – Donna Himpler
  • WA Trust Bank – Kit Gerwels

Time for Thinking

Recent weeks and months have been traumatic. In business June was the quietest for us in three months. As quiet to the first couple weeks of the virus shutdown. The disgusting murder of George Floyd on top of the virus sure has changed our lives. I’ve put a lot of thought in all that’s going on, done a lot of reading, and listening. About those disenfranchised by society and those whose businesses and lives have been ravaged by a virus and then by looting.

Bottom line: I can put up with our business being slow for a while (repeat, for a while) if it leads to the societal change we need. Because if change truly occurs it will benefit all of us in many different ways (not just economically).

For perspective, we have a son-in-law who’s a police officer. I had three or four high school friends become police officers, two very good friends; guys with whom I played rec softball and touch football. One of those friends was murdered at age 29 when he served a (rather insignificant) warrant, the recipient pulled out a gun, and put a bullet in his head. His partner would have also been murdered but the killer’s gun jammed.

At the same time, some of my best friends are Black. I’ve known people who have been “targeted” based on their race. It happens and I know because I’ve been on the periphery of it. While not nearly the same, a number of years ago we were in Scottsdale over New Year’s, I went out for an early morning walk around the resort grounds, and because it was about 40o I had on a sweatshirt with the hood up. Out of the corner of my eye I saw a security guard on a Segway, and he was following me. Once he saw I was a white, middle-aged guy he left me alone. Hmmm, if I wasn’t would he have acted different?

I’m a believer in the 80-20 rule (sometimes more, sometimes less). In my opinion:

  • 80% (or more) of police are good.
  • 80% (or more) of protesters are well meaning.
  • 80% (maybe 98%) of politicians are in it for themselves not you or me.

So we know this stuff happens and it’s not from the good 80%. When I hear the president make comments encouraging violence against peaceful protestors it nauseates me. Just as it does when criminals hijack peaceful protests in order to steal and destroy. A destroyed small business will devastate the owner (see the front page of the June 4 Wall Street Journal about looting in small, minority owned businesses), his or her family, and the employees, who may have a hard time getting another job or getting unemployment given the ineptitude of the Unemployment Department, at least in Washington. 

Unfortunately, there’s no easy solution to all of this other than to do our part and have more acceptance. On one of our Rotary projects in Antigua we were having a discussion and one of my (Seattle) friends said, “People are people. Some are fat, some skinny; some tall, some short; some smart, some not so smart, some black, some white, but people are people.” And that really sums it up.

Education is one of the foundational pieces and we can’t keep having such educational disparity. More education, less dependency on government assistance, and a better life for all as life in general and the economy are not zero-sum games. It takes all of us doing a little bit. Business is business and there are more important things in life.

“Hell is boiling over/And heaving is full/We’re chained to the world/And we all gotta pull.” Tom Waits

The gang that couldn’t fly straight

A few months ago, the Wall Street Journal had an article on Boeing’s recent problems titled, “The Gang That Couldn’t Fly Straight. It covered how Boeing got so off track. I’m not qualified to analyze Boeing’s issues and the article made it seem they made some decisions based on numbers versus the planes or the people. It reminded me of when in “The Reckoning,” David Halberstam wrote about Lee Iacocca’s outrage because the financial people, who had such power at Ford, had “so little feel for cars.”

For many years there was an incredible demand of planes. Did Boeing lose their “feel for planes?” (and for people?). It was boom times for sure as it was for many other businesses. It caught up with Boeing and it’s catching up with other businesses. As I heard on a recent webinar, “Any company can do well in a boom.”

When things are easy there’s less attention paid to the details, especially the details about what a business buyer will want. Here are some examples of businesses I’ve seen in the last month or so.

  • A proprietary product manufacturing company with an 82-year-old owner who is (still) the product designer, especially for the little tweaks each customer wants. 
  • A booming manufacturer with 90% of sales to one customer. The customer is no longer local and supposedly uses this firm because they can’t find a supplier near their current location. What happens when they do find a nearby supplier?
  • A firm reduced to a skeleton staff due to COVID, their best month over the last three showed sales at about 30% of last year, and they want to sell for a large, guaranteed price.
  • A very solid consumer business wanting to capitalize on a COVID spike in business, assuming (hoping) it’s a trend. Deeper analysis of sales shows it most likely is a spike.

Once again, it’s easy when things are booming. But business buyers want to know what happens when it’s not booming, when dependencies like the above owner and dominant customer manifest themselves, or what COVID and other risk factors do to the business. 

And speaking of COVID and how it’s affecting buy-sell deals, here’s what my friend Gregory Kovsky with IBA wrote me, “…until a business shows three months in a row substantially similar to 2019 prior to believing it has returned to its prior strength and where historical valuation models are appropriate.  Until that occurs, I believe some adjustment mechanism is warranted related to the ultimate value of a business in a transaction paid by the buyer to a seller.” For those of you not in the buy-sell industry, it means the buyer probably won’t guarantee the full price upfront, will pay a lower price, or a combination (or some other adjustment technique).

The value of a business is really what a buyer will pay for it. Too many risk factors and the price goes down. And the bottom line is, many of the risk factors present in small and mid-sized businesses can be mitigated over time. It takes awareness and effort. With COVID, we just don’t know.

“There seems to be some perverse human characteristic that likes to make easy things difficult.” Warren Buffett

Business Valuation and Deals During COVID, and Other Turmoil

I’ve been asked by quite a few people for my thoughts on business valuations and deals during the COVID-19 crisis. I’ve also been asked if there will be a lot of “good deals.” Here are my thoughts, the first one being extremely important.

There will be no “deals” on good businesses, i.e. ones that survived or thrived during the virus crisis.

My second thought is almost as important:

Nobody really knows what’s going to happen. If they say they do (know) watch out because the BS meter is in the red zone. We’re in unchartered territory.

Good businesses include many essential businesses, especially those whose customers are essential, whose suppliers are essential, and can show their performance is sustainable, i.e. not a temporary spike. For businesses like this please keep in mind, the seller will control the deal.

Where will there be “deals?” They’ll be on hurt businesses, which is the only time a buyer will control the deal. But who wants a hurt business? One with long-term damage? In my opinion, it will most likely be another company in the same or similar space. A company that can absorb overhead, create synergies, wants good employees, etc. Maybe even a job for the seller. And this is where the buyer can control the deal. Most financial buyers won’t want a hurt company.

Before I get into valuation, here are some other things I expect we’ll see:

  • More seller financing, in fact banks are already indicating they want more seller financing.
  • More buyer cash at closing, banks will shy away from the 10% down from the buyer (SBA loans) and want it at least 15-20% if not more. 
  • For businesses successful during the virus crisis, an emphasis of analysis will be on: is it a spike or a trend; who’s creating the increased sales; what product mix is being bought; what type of customers, etc.?
  • Expect business sellers to take longer than buyers and banks and CPAs to adjust to the new norm of deals, including that more patience will be needed as deals will take longer to close. Us intermediaries will adjust pretty fast; we’re seeing firsthand what’s going on in the market.
  • More emphasis on current financial statements, meaning monthly statements with comparisons to the previous year.
  • Buyers, banks, and intermediaries wanting to see a number of months back to normal or on the right track before committing. 
  • More COVID related due diligence (some banks have COVID questionnaires), more attention to intangibles, detailed diligence on any PPP funding; and industry experience will be a big plus for buyers.
  • Banks will be running more and tougher stress tests on all loans (meaning, looking at more scenarios of debt coverage if sales and earnings decline).
  • More earnouts, i.e. part of the price based on performance. Or, claw backs, which are a negative earnout if future numbers are not hit and which is how any variable pricing has to be handled for an SBA loan.

I started with statements about deals and forecasting. My third statement is about valuation:

It will be trickier than ever to value many businesses.

I’m regularly asked, “What’s the multiple for this business?” or someone will say, “I’d pay X times EBITDA for that company.” As I like to say, there is no set multiple for any business or industry. There’s a typical range (different ranges for micro, small, mid-sized, lower middle market, etc.) and where in that range a business’s value falls has to deal with the risk and reward factors, i.e. the non-financial factors, such as:

  • Customer concentration or diversity
  • Dependency on the owner or key employee
  • Growth potential
  • Regulations
  • Suppliers
  • Barriers to entry
  • Competitive advantage

In 2020 we have to add:

  • Government intervention (for example, essential or non-essential)
  • Safety of employees and its cost
  • Very recent history (months not years)
  • The COVID affect, short, medium, and long term
  • Customer demand for companies where in-person activity is required or suppliers to those firms – think airlines plus their effect on Boeing, Boeing suppliers, hospitality, recreation, etc.

In other words, there are a lot of unknowns. Historically, the first set of risk and reward factors above are known, or pretty much known. The second set are ambiguous and even the recent financial statements will need to have an analysis to see if recent performance is sustainable or a “V-shaped downturn and recovery” or a “long-term trough.” An appraiser will be a bit more analytical with these new factors than a buyer (or seller) will be. Buyers will rely more on gut feel when it comes to the price they’ll pay, and how they’ll pay it (which is different than the value an appraiser comes up with). The seller’s gut will still tell them their business is the greatest thing since cold beer, sliced bread, or whatever cliché you want to use. Bankers will be digging deeper than ever because, and this is obvious, they want to get paid back.

Appraisers use historical financial information and cashflow projections. If it was me, I’d be very cautious using projections and if I did, I’d want to see the projections the company had in their 2020 budget. I recently saw a valuation with a 10-year projection of revenue and profits. Ten years? It’s hard to project 10 months. Heck, it’s hard to project even 10 weeks. Based on surveys I’ve seen, about 75% of small to lower middle market firms have seen a sales decline this year. In other words, smart people will be comparing a company’s projections to their past projections and performance.

Conclusion

There is no one size fits all answer. If the business has stayed on course or showed sustainable growth the value will increase, and the price paid will probably increase even more. If the business has suffered, watch out, the value will be a lot lower, buyers will be skittish, and even more skeptical than ever. For those in the middle, not growing but not suffering, maybe having slightly lower earnings, it’s going to be “beauty is in the eye of the beholder.” The same ranges of value will hold true with more companies on the lower end with earnouts allowing them to climb higher in that range. I wish there was a more clear-cut answer.

Don’t Assume a Universal Based on Your Situation

I was on an online discussion event recently when a lady said (and I summarize), “Nobody will want a car anymore because we’ve shown we can work from home and have things delivered.” My reaction was, that’s really stupid. She took her situation and applied it to everybody (both all people being able to work from home and about the need for cars). And someone, somewhere is paying her for insight like this?

How wrong was she (about the cars)? It seems very wrong given on May 16 the Wall Street Journal had an article about how auto manufacturers are gearing up. They’re assuming, and hoping, the rest of the world emulates China where auto sales are skyrocketing because people don’t want to ride buses, subways, trains, or be in an Uber, Lyft, taxi. (There have also been articles about how car rental companies may flood the market with cars for sale given their industry was hit so hard.)

The business point here is, don’t rush to judgment, especially based on an isolated instance. At this time, we have people predicting a slow recovery, V shaped recovery, and everything in between. And the stock market is its own animal. My comment is the recovery will be different for different industries. I do think it safe to say storefront businesses will really have to depend on how comfortable customers are returning (versus it being about the business owner wanting to open).

What’s Going On*

Over the last couple months I’ve been on a lot of webinars, Zoom meetings, and other online events, as I’m sure many of you have. Besides my Zoom Business Social & Happy Hour events I’ve attended ones hosted by Business Brokerage Press, Mark Cuban, Alan Weiss, Ted Leverette, Patricia Fripp, and others. Here are my take-aways from them, in no particular order.

  • Make a great first impression, including on social media. Be polite and appear better than others.
  • The best thing to do with employees is communicate and make them feel comfortable. More communication than ever as it will create trust.
  • Ask your employees! And don’t use language of war and fear.
  • What would you do different if starting your business now?
  • It’s important what business buyers say to sellers and brokers (first impression). It’s equally important what business sellers and brokers say to buyers, especially qualified ones.
  • We all need direction not conditions. You have to be for something (which reminds me of the verse from Hamilton, “If you stand for nothing, Burr, what’ll you fall for?”).
  • Be a sounding board and authentic.
  • There’s more “checking out” others than ever. What do people see when they Google your name?
  • People are terrified and scared.
  • Be a resource; write a lot of content.
  • Internet marketing will stay strong.
  • What’s going on should make us willing to look at different ways to do thing.
  • An upside to Zoom, Teams, WebEx, etc. is you get to see people as they live, not as they present themselves for business. Their kids, dogs, cats, etc. let you get to know them better.
  • We (our clients, customers, and ourselves) seek validation.
  • Any company can do well in a boom.
  • Ask, what will change forever?
  • Some owners won’t have the stomach to keep going (and will want to sell).
  • If you’re not changing your marketing be prepared to do so.
  • You will recover.
  • Errors are seldom fatal.
  • People crave confidence.
  • Don’t use this situation for procrastination.
  • Be present online with 60% tips and 40% sales related.
  • Block people on LinkedIn who ask to connect and then try to sell you something.
  • From an insightful PE guy before it really hit the fan – expect GDP to decline by 10% or more, unemployment to hit 15% or more, and it will be really tough for many people for 18-36 months.
  • He also said entertainment won’t return soon and as an example noted Taylor Swift cancelled her tour even though 15-31-year old people don’t seem to care about anything (like the virus).

* Thanks to Marvin Gaye for the title. J

Buy-sell Earnouts, Litigation, and the Changing Landscape

On May 12, 2020 GeekWire reported Seattle company Porch is being sued by Kandela, a company Porch acquired in April 2019. The basis of the lawsuit is Porch did all they could to stunt Kandela’s growth and profitability in order to avoid paying an earnout. If you’re not familiar with an earnout, it’s similar to a salesperson’s commission in that payment is based on performance.  

The Porch lawsuit alleges they (and this is from GeekWire), “have engaged in a stunning and systematic pattern of fraud designed to prevent Kandela from achieving any earnout” for hitting certain milestones, according to the complaint. They went on to say Porch withheld resources, refused to sell Kandela products (to Porch’s customers), and more. 

It’s why lawyers will joke and say the only winners with an earnout are the litigators. That said, in our pandemic world, everybody I’ve heard from believes earnouts will be more prevalent. And as much as I don’t like them, other than for special circumstances, I agree with this and have a business buyer client making an offer with a significant earnout component as the business has been hurt by the pandemic, and nobody knows how fast it will come back or at what level.

My advice to my client was: 

  • Keep it simple.
  • Make sure the seller can easily get to and see how he can get his full price.
  • Emphasize your goal to make the recovery as fast as possible (it’s in the buyer’s best interest anyway).

There are a lot of people out there who think there will be “deals” on business acquisitions. There will be on damaged companies (a deal meaning a lower price albeit for a company with less profit), there won’t be on solid companies, and earnouts will play a part in more deals than before (as will more seller financing). The objective is to have it be fair to both sides and be easy to figure out.

“Don’t gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.” Will Rogers

Not Rehiring? More Business Ownership?

Over the last four years we’ve tracked every incoming referral. We note the date, source, and type (business buyer, seller, exit planning, etc.). There’s no pattern, that’s for sure. But there’s been growth and consistency within a tight range. 

That is until mid-February of this year when, guess what, a certain virus started making headlines. Over the next 10 weeks we got a total of two referrals. Then, six in 10 days. 

My thoughts:

  • There’s pent-up demand to get going again. 
  • Maybe (former Presidential candidate) Andrew Yang is right when he says companies have been looking to shed workers (before the pandemic) and won’t be rehiring them. They’ll run leaner.
  • I wonder if managers and executives are sensing this and starting to think about controlling their career destiny via business ownership.

Speaking of business ownership, there are only three ways to get into business. You can start one, invest in a franchise, or buy an existing company. Preferably a mature, profitable, and fairly priced company (disclaimer: this is where I come in, helping people buy the right business the right way).

Buying the right business the right way means separating yourself from the bottom-feeders that have come out. I’ve talked to numerous owners in pandemic-distressed industries (and to other advisors). They tell me the bottom feeders will say things like, “We’ll get you out of your business by purchasing your customer list,” or, “We’ll buy your (tangible) assets.” No mention of what happens to the seller’s lease, equipment payments, etc. 

“There’s gold in them thar hills” (Mark Twain, The American Claimant, 1892). Unfortunately, some businesses won’t make it and this means opportunity for others. There will be openings for acquisitions (second disclaimer: I wrote a book titled, Company Growth By Acquisition Makes Dollars & Sense). And I mean fair acquisitions to bail out a bad situation, and maybe even a job for the seller. 

A crisis like we’re going through brings out the best and the worst in people. Be part of the best, not like the bottom feeders. 

“A ship in a harbor is safe, but that’s not what ships are for.” (Author) John A. Shedd

Make a Decision

One could write a long essay on businesses lessons from the virus crisis, there are so many, both good and bad. One of the top lessons is about making decisions.

Here in Washington, our governor does not like having to make decisions (other than, it seems, to be in charge of everything). He waffles, postpones, is forming committees (and we know how efficient and effective government committees can be), and is creating backlash.

While I’m not in New York, Georgia, or California, it seems those governors are much better at making decisions. Whether you agree with those decisions (or if their decisions worked out okay) is not the point. They’re taking action. 

Many years ago, a very wise and experienced businessperson told me one of his best attributes was to make a decision and move on it. He said even if half of his decisions were right, he was way ahead, versus not making a decision. And then there’s Grantland Rice who said, “A wise man makes his own decisions, an ignorant man follows the public opinion.”

Tying it to my business, during buy-sell due diligence, some buyers get analysis-paralysis. They need to make a decision and move.