It’s the Simple Things

Reading about the University of Washington’s big victory over rival Washington State I noticed the following from UW defensive coordinator Pete Kwiatowski, “When you beat the guy across from you, it’s a simple game.”

It always comes down to doing the basics. As I’ve told my clients for years (and mention in my book, Buying A Business That Makes You Rich) when you do the things you’re supposed to do, good things happen.

For business buyers, this includes implementing a comprehensive search system, building a relationship with the owner/seller, realizing the vast majority of sellers care about their employees and legacy, and recognize you want to pay a fair price for a great business.

For business sellers, the number one overriding “simple thing” is making sure your business is ready for the buyer’s in-depth analysis. My top four things are – show growth, reduce dependencies (especially on the owner), have solid financial systems and accurate financial statements, and demonstrate how you attract and retain great employees.

And for increasing sales, whether you’re an advisor, banker, business owner, or employee, it comes down to constantly and consistently getting the word out about the value you provide. You may set a goal of increasing revenue by 18% but if you don’t market, make telephone calls, or see people how the heck will you achieve your goal?

Know Who is Your Best Customer

The Wall Street Journal recently published an interesting article on how banks are reducing the number of branches. They explained how Bank of America, using Indiana as the example, is overall reducing the number of branches but the steep cuts are in small towns as they add branches in Indianapolis, especially the more affluent areas of the city.

If we look at car dealers, we see the (ever shrinking) auto section in the paper doesn’t have ads for Lexus, BMW, Acura, Audi, etc. The ads, shouting out low prices, are for Ford, Chevy, Hyundai, Dodge, and similar.

In both cases it’s using data to reach the target customer. The same techniques should be applied to small business, even though most don’t have anywhere near the money or data to fine-tune it as much as big business can. It comes down to knowing where your customers are so you can reach them most effectively.

The same holds true in business buy-sell. Sellers need to know who their best buyers are (the logical buyer) as a quality buyer is worth more than a higher price (a buyer recently lost a deal when someone offered more money and now the seller wants to reopen communication because the higher price came with baggage, that being a not very good buyer).

Buyers need to know what they want, not, “I’ll know it when I see it.” This means a lot more than business type but understanding how they will fit into the operations. For example, a manufacturing engineer is probably not going to be good with a pure sales organization, and a sales guru won’t do well running a process oriented manufacturing business.

Know what you want, who your customers are, and go after them in the best ways possible.

 

Relationships Rule

The other day I was on a conference call and heard a business seller give a very eloquent explanation of why he wants to sell his business to a particular buyer. He mentioned numerous things, including he’s a good person, he’ll preserve the culture, we share values, I don’t want to sell to a large company, etc.

Every year there’s at least one deal where this happens (the extreme is when the owner sells to someone she likes for a price lower than someone else offered), or a buyer says he won’t negotiate much because he really wants the business, one reason being how much he likes the seller and what the seller has done with the company. Buy-Sell is a microcosm of all business and life, i.e. relationships are the most important thing there is.

I (over)emphasize this in my books, Buying A Business That Makes You Rich and If They Can Sell Pet Rocks Why Can’t You Sell Your Business (For What You Want)?).  Small and mid-sized business transactions won’t happen if the buyer and seller don’t get along. Getting along great doesn’t mean there’s a deal, it means you have the potential for one.

Just like life, right? We hire people we relate to, we hang around with people we like, we date and marry people we get along with.

Many years ago, I learned a lot from a program called “Counselor Selling.” Having never been in anything close to sales before it opened my eyes to how important relationships are. Want to do business with someone, build a relationship before talking about product.

Adapt or Perish

It’s interesting, and a bit sad, to see town car drivers waiting and waiting and waiting outside of hotels as Uber and Lyft cars come and go with passengers. As much as the ride companies disrupted the taxi industry they did the same, or more, to town car industry.

Or at least they disrupted the drivers who still do things the same way they did five years ago. I look and see how my clients’ businesses and my business have changed over the last five years and how others haven’t changed at all. And it’s not just technology. Often it’s speed. Speed to market, speed to getting in front of customers, to getting the job done.

Your customer/client is better off if you solve their problem sooner versus later. From advice, to product delivery, to having a car when and where you need it, with you being in control of the ride

Political Shenanigans and Business Buy-Sell

In the recent news is the story of how Pakistan’s Prime Minister Nawaz Sharif was removed from office based on corruption charges and not being “honest.” I’m guessing there were some political motivations behind this.

What was reported by only some outlets was one of the key pieces of “evidence.” Some London real estate was owned by his children and his daughter produced a document showing she was not an owner but only a trustee of some offshore accounts. The problem is, while dated in 2006, the font they used wasn’t commercially available until 2007.

This sounds like something out of the young-person mystery. The teenage detective foils the bad guys by showing they used a non-existent font on their old documents (while all the adults debated and argued).

I don’t see things this blatant in the buy-sell world. What I see are people who disguised a business’s profitability by using Adjustments, Assumptions, and Add-Backs (to, of course, inflate the true picture). For more, see my article at https://www.martinkaconsulting.com/wp-content/uploads/2013/12/AAA-not-to-the-rescue.pdf.

The Rotary Four-Way Test starts out with, “Is it the truth” and it’s a great motto to live by.

Why Your Lease is Important

When in New York, my wife loves going to a clothing store called New York Look, where she’s befriended one of the employees who helps her with what she buys. There used to be four of these stores and now there’s one.

One of the more recent closures was a store near the intersection of Central Park West and Central Park South (where a new Nordstrom Tower building is going in). Supposedly the lease was up and the landlord wanted to triple the rent, to $95,000 a month. A lot for a small, locally owned store so I’m sure they’ll soon be a luxury brand in that space.

This is why the banks insist, as should business buyers and sellers, the buyer have a lease, with options, at least as long as the term of the loan. Getting forced out is not good for business, or loan payments.

Business Valuation Lessons From ESOPs

I’ve been working with a client company on the implementation of an ESOP (Employee Stock Ownership Plan). In an ESOP, a qualified plan, the plan buys the stock of the firm from the owners with vested employees now the owners, en masse. One of my roles was being on the team interviewing the critical (and very expensive) ESOP advisors. There’s a Third-Party Administrator, Attorney for the Company, Trustee, Attorney for the plan, and business appraiser (and I found most appraisers don’t do ESOP valuations).

The trustee is the one (individual or firm) with the most on the line, i.e. risk. It is their job to make sure, among other things, the valuation is fair to both sides. My first question to all of them was, “What are the common traps and how do you and we avoid them?”

In every case the answer was, “the valuation.” I’m going to go through the three issues emphasized as potential problems.

Projections: The real hot-button is projections and their validity. Regular readers of this newsletter, and viewers of my video podcasts, know my feelings about projections in the buy-sell world, I feel they’re useless. Everybody projects a nice steady growth rate with even rosier growth of the bottom line.

The trustee of an ESOP is mandated to make sure the firm and the appraiser provide and use justifiable projections. They look at past projections and compare them to actual growth. If there’s a large variance they will call it out. The biggest issue, that can cause the plan and trustee grief, is a valuation (especially when partially based on projections, which is always done on ESOPs) benefits the sellers over the employees, who are the new owners. This means a value derived from optimistic projections.

This is just like in my world; a buyer shouldn’t overpay because they optimistically bought into wonderful projections. But what about in other aspects of business? Salespeople shown how high their commissions will be when nobody has ever previously achieved those levels is just one example.

Methodologies: The second red-flag topic is the improper use of valuation methodologies. An outsider may ask, how is this possible? It’s because there are a lot of assumptions in business valuations, which makes valuing a business an art as well as a science.

  • In the Discounted Future Cash Flow method profits are projected (same as the first issue) and discounted back to a present value. High or low projections, an inaccurate discount rate, or other things can manipulate the end result.
  • In an occasionally used method called the IRS or Excess Earning method, it’s simple to influence the result, just change standard goodwill ratings scale from 1-6 to 1-10. A well-run company rated a 5 out of six (a 20% ROI) is now an 8.33 (same rating percentage but now a 12% ROI).
  • Using comparable sales of much larger firms will distort the value. Imagine a home appraiser comparing a 3,000-square foot house on a cul de sac with 10,000-square foot homes on the water.

Price-Earnings Ratios: A big issue raised by the trustees was the improper use of price-earnings ratios (aka the multiple of earnings), specifically using publicly traded company ratios when valuing small to mid-sized (and even middle-market) firms.

As I write this, according to the Wall Street Journal, the current PE ratio for the S&P 500 is 25.89. For a recent assignment, I researched this subject for private businesses and the PE ratio for middle-market companies is just under 7X (as per GF Data, provided by my friend John O’Dore with One Accord Capital) and just under 4X for small businesses, $1-15 million in sales (as per PeerComps, a database I subscribe to, which is SBA business acquisition loans). For reference, a check of major bank PE ratios shows they are at about 15). Use 15X instead of 4-7X and not only do you inflate the value, you’ve committed fraud.

Conclusion

ESOP trustees have a lot on the line. They have valuation experts on staff to review what the independent appraiser did, because any misrepresentation comes back on them (in the form of a lawsuit).

In my buy-sell world, it is less “regulated” and the above regularly takes place by buyers (trying to deflate the value) and by sellers (hoping to inflate the value). The previous paragraph on PE ratios confirms something I’ve been saying for years, there is a standard range in which businesses sell. For small businesses, it’s 3-5 times profit (after fair market owner compensation). In the PeerComps data (over 9,000 business acquisition loans), the coefficient of variance was just over 25%.

This means the range of the average multiples, which is 4X, was just over one point above and one point below, or about 3-5X. There is a wide range because of the difference, firm to firm, of the non-financial factors including customer concentration, management quality, dependency on the owner, and more. An average of 4X doesn’t mean they all sell at this multiple, some are higher and some lower. But it also doesn’t mean a small business will sell for 7X or a middle-market business will sell for 15X (without very special mitigating factors as there are always rare exceptions).

Going back a few years (more than a few), from the TV show Hill Street Blues, as Sergeant Esterhaus would say, “Hey, let’s be careful out there.”

 

 

Distractions are Everywhere – Avoid Them

Everywhere you look there are distractions. Just think about it:

  • All the advertising with which we’re constantly bombarded.
  • And if TV, radio, and print weren’t enough, there’s also the Internet and social media.
  • In sports, the opponent wants you to think they’re going right when they really want to go left, that they’ll throw a fastball when they’re throwing a curve, etc.
  • In politics distractions are created to take the voters’ attention off the fact nothing much constructive gets done as promised.

But nowhere are distractions more important, and annoying, to us as when they attack us on a daily basis. Years ago, I had regular breakfast meetings with a friend in a complementary business. At one point his company went virtual, he was working out of his home, and I remember him telling me how tough it was to stay away from the refrigerator.

This doesn’t mean there aren’t distractions in an office setting. Offices have refrigerators as well as coffee machines, water coolers, cubicles, and other people. Managing those distractions is what allows for productivity increases, especially when we don’t let them get in the way of what’s important (see my memo on the book Rest and how humans are “wired” to be super-productive four hours a day).

I see how distractions get in the way of my clients and other business owners. It takes a lot of focus to not let them get in the way. In the buy-sell world, I have to make sure my clients don’t get off on tangents not important to the deal. Those tangents are alluring because they’re “fun.” Or shall I say stress relief from what really needs to be done.

It can be very beneficial to close your email program, turn off your phone, close the door, and get the important things done.g

“Don’t let the dog bite you twice.” Chuck Berry

 

It’s Counter-Intuitive – Buy the Company and Lower Prices

The news has been filled with stories about Amazon buying Whole Foods, what might happen, and what did happen. I liked the pictures in the Wall Street Journal showing the price of bananas before and after the deal closed.

Amazon did something counter-intuitive, they lowered prices (supposedly on about 100 regular items, like bananas). One of my favorite stories of how a buyer fixed a company is about when he raised prices about 25%, because he knew the company was severely under market (and no customers left or even complained).

Most new owners look for fat to trim and there’s often a lot there. It’s just like all the storage areas in our homes. After years and years, we suddenly realize we can’t navigate through the attic or closets because there’s just so much stuff. A lot of businesses build up expenses and don’t notice if there are duplicate services, what they have is overpriced, etc.

Amazon’s strategy will no doubt work. They’ll get people in the stores because now they’re competitive on the things we always buy (the Seattle Times just did a comparison on prices for common and not-so-common items between Whole Foods and other stores). Once their people will buy other things because it’s easier and cheaper to pay a little more versus traveling somewhere else to save 43¢ per pound.

The best strategy is to get a customer because if you do what you’re supposed to do you’ll keep them. And, all the studies I’ve seen say it’s 6-10 times more expensive to get a new customer versus doing more business with an existing customer.

“We will not make the same old mistakes. WE will make our own.” Henry Kissinger

The Murky Ground

A recent business section in the Wall Street Journal had the front page, top headline of, “Google Pays Up for Fake Traffic.” There are refunds going to marketing firms for ‘bot’ fraud, when ads ran on fake websites.

We all see stuff like this every day. Not advertising clicks, but the misleading information put out by many. My daughter is in the midst of a job search and tells me all the time about misleading job descriptions. She’s come to appreciate how most companies now do the first interview by telephone because she can eliminate them without taking hours to commute and meet in-person.

In the small to mid-sized business buy-sell world misleading information is common. It’s rare to see a company for sale that is not the “industry leader,” provides the “best service,” has “no serious competition,” or is not the “premier” firm in their industry.

Then we get to the numbers and boy do things get murky. First, small business accounting is nowhere close to GAAP accounting (generally accepted accounting principles). It’s more like creative accounting with misclassified accounts, no pattern of what goes into cost of goods sold, etc. Comparing margins to industry norms is virtually useless.

Then we get to all the efforts to make a business look better than it really is. I’ve written on this before (see my website for an article and video on, “AAA – not to the rescue,” about adjustments, assumptions, and add-backs to manipulate the real profit of a firm). It sometimes makes me laugh to see how few expenses some owners claim are really needed to run the business. During one recent analysis I said, “If the seller keeps this up we’ll find the business can run with no expense.”

“The hardest thing to understand in the world is the income tax.” Albert Einstein

Go to https://www.martinkaconsulting.com/media/podcasts/ for an audio version of this memo.