Coasting – Downhill

A business owner told me his sales were X dollars – put in whatever figure you want, $100,000, $1,000,000 or $10,000,000. His actual sales were:

  • 2017 – 90% of X
  • 2018 – 75% of X
  • 2019 – 65% of X
  • 2020 – on track for 50% of X 

The abovementioned owner is coasting and the business is going downhill. And once on the slope it’s tough to recover. I’m sure there’s not a lot of calling to customers, much less prospective customers. I can’t imagine there’s much marketing at all.

What’s compounding this is he has no idea of what’s really going on. Yet all it takes is paying attention to the financial statements. He doesn’t need to have management reports, although they would add a lot of value and clarity.

Business buyers want one of two things:

  • A well-oiled machine with room to grow.
  • An underperforming business in a solid industry (coasting).

What they rarely want is a damaged beyond-repair business. Whether you’re an owner or advise owners, keep these points in mind. Coasting (downhill) doesn’t let you exit with style, grace, and more money.

“If liberty means anything at all it means the right to tell people what they do not what to hear.” George Orwell

Over Promise; Under Deliver

I’ve had a security camera in our house for a couple years now. I won’t mention the company name (they’re local) as the main subject of this memo is about their announcement that while their cameras came with free storage for their person detection feature, they’ve realized it is way too expensive to provide it (to over 1 million customers). They’re not going back on their agreement but rather asking customers to voluntarily pay for it.

My first thoughts included the title of this memo, over promise and under deliver, plus didn’t they see Apple, Amazon Photo (for videos), and Google Drive offer some free storage and then charge, and did they get caught up in the creative process and not pay attention to the budget?

So, what can and should businesses do? Here are five tips:

  • Plan – a good plan will cover things like this and put them to the stress test, i.e. what if people use a lot of storage?
  • Budget – here’s where I’m a bit baffled by my above example because this company has raised over $35 million and much of it from some pretty savvy investment firms. Didn’t somebody catch this? A good budget will run different scenarios from slow to fast growth and usage.
  • Realize, growth sucks cash – super fast growth can be as bad to a company, especially a new company, as slow growth. 
  • Know your market – as mentioned, if the big players like Apple, Google and Amazon don’t offer unlimited free storage why should this firm. It reminds me of something about 10 years ago in my Rotary Club. When expanding our fun run from a 5K to also have a 10K we discussed pricing. One of the number cruncher types said (and I’m not making this up) we should figure out how much we want to raise and divide it by how many people we think will run. That would have given us a fee 2-3 times the market rate and Econ 101 says price elasticity would have driven those numbers way down.
  • Get help – pilots don’t fly solo the first time out and neither should any of us with a (new) business.

The above is speculation as I’m not privy to all the inner workings of the company. But when a business has to retreat from a promise, which was probably a selling point to some customers, it warrants comment. As always, it often comes down to paying attention to the basics.

“To err is human – but it feels divine.” Mae West

Owner Versus GM and a Feel for the Business

It happened again. It shouldn’t surprise me, but it always does. Maybe I’m too optimistic about successful people knowing what they’re doing. 

A burned-out business owner hired a general manager so he could step back and clip coupons.  Of course, the manager didn’t have a “feel” for the business, made changes, and proved it’s rare when a non-owner manager can do as well as someone with a vested interest, i.e. the owner’s money (at risk). Now the owner is back in the company, more burned-out than ever. This is why I did a video podcast on this subject, which I titled, “Small businesses need the adult supervision only and owner can provide.” 

When does it work? To me, it seems when it’s not the founder stepping back there’s a much greater chance of success with a manager/COO. The founder has (typically) done things “their way,” knows the little intricacies of the business they often don’t’ share with others, and hasn’t built a solid management team (and if they have, they often don’t delegate as they should).

A buyer/investor who is used to a board of directors, delegating, not knowing the nuts-and-bolts of the business does better when not in the business day-to-day. They’re used to a chain of command and holding people accountable. 

Back to the story at the beginning. The value of the business is much lower than it was two years ago (lower based on the above, nothing to do with Covid). This foray into a manager with an inactive owner cost him millions. And, it proves that the salary to an owner is not discretionary. The owner earns their keep and it’s a legitimate business expense. 

On September 9 I’m on a panel at the (online) meeting of the Northwest Family Business Advisors (www.nwfba.org)on the topic of “Selling a Family Business.” I may use the above story and definitely plan to emphasize how owner salary is not profit, it’s an expense for valuable work.

“The greatest enemy of knowledge is not ignorance. It is the illusion of knowledge.” (Historian) Daneil J. Boorstin

Be Like Oliver; Do a Little Extra

My wife and I were having dinner last week on the new deck at the Wallingford Tutta Bella along with Joe Fugere, the owner (not name dropping, him being there is integral to the story). It was a beautiful evening and as we shared a dessert and had an espresso, we noticed a young man, Oliver, walking around outside the restaurant.

He eventually went in and then came out to the deck. After a while one of us asked if he needed some help. He didn’t, it turned out he was there looking for a job. He finally met with the manager who must have told him the owner was outside because he came over to Joe to tell him how much he’d like a job at Tutta Bella as he really wants to work in a restaurant.

After he left, we talked about how he did what he did. He didn’t just apply online. He went out of his way to take advantage of the owner being there. And the benefit was Joe gave him some tips and actually went online to write on the application that he (Joe) recommended Oliver. I commented I hope he’s as good an employee as he is being aggressive to get a job.

Six months ago, Tutta Bella and most other businesses were clamoring for employees. Now, the prospective employees have to take action. And it’s not much different for most of our businesses. We have to be aggressive and creative to generate business (or get a job). What worked 6, 12, 18 months ago doesn’t necessarily work now.

We are constantly trying new and different strategies to keep our name in front of referral sources and prospective clients. Like many businesses I see, every potential customer is valuable.

“One of the difficulties of being alive today is that everything is absurd but fewer and fewer things are funny.” (Humorist) Alexandria Petri

When Family Ties Don’t Bind: It’s Trouble Succession Planning Gone Wrong

The July 11-12, 2020 Wall Street Journal had a fascinating article on the dysfunctional British Barclays family. It’s a good example of why it’s great to plan and at the same time the plan must be solid and emotions can’t play (too large of) a part.

The simple story is how the now 85-year-old Frederick and David Barclay built an $8.8 billion empire from nothing. Literally nothing, no inheritance from dad or grandpa, no government grant, etc. They were a team, described as inseparable. They owned London’s Ritz Hotel, the Daily Telegraph newspaper, an online retail business, a logistics and parcel-delivery company, and more. They were noted for being adept at buying and selling companies. 

One good thing they did was start the succession planning process about 30 years ago. How they did it makes one wonder how such smart and successful people can make what appears to be basic mistakes. For one, a big one, they decided three of David’s kids would each get 25% and one of Frederick’s kids 25%. Given they were 50-50 partners does this make sense? Frederick now says he felt sympathetic for his brother because he was ill at the time. This is where the emotions come into play; the hugging at the heartstrings. 

Fast forward to recently and it sounds like a bad reality TV show with secret meetings, bugging meeting rooms, etc. No trust, damaged relationships, and a waste of time and money.

If the article is right, a big mistake was trusting others, even family members. As President Reagan said, “Trust but verify,” which leads me to offer some thoughts on succession planning in general.

  • Don’t get overly obsessed with succession to your kids or grandkids. It has to make sense for all not just the desire to have your kids continue on with what you started (or bought).
  • Get advice from experts and pay attention to it. They’ve been there, done that.
  • Start early (the Barclays’ did).
  • Make sure it follows Rotary’s 4-Way Test and “Is fair to all concerned?”
  • Think through it, there probably isn’t a rush.
  • Monitor what you did, things change.
  • Consider all options including family, management, outside investors or buyers.
  • Know what’s driving the process. Is it money? Is it legacy? Is it giving your kids or team the business? When you know this the rest will be a lot easier.
  • Once you do it, get out of the way. Dad and/or mom can’t hang around too long or be too involved. A board seat is fine, coming in every day to look over your successor’s shoulder doesn’t work.
  • Relationships rule in buy-sell deals. When there are multiple family and/or management members make sure there are good relationships, or you’ll be doomed, and probably back running the business.

It has to be a fair deal. Mom can’t give the business to her son or daughter. Dad can’t go for the jugular moneywise like I wrote about many years ago when Seattle institution Larry’s Market went under. My theory was the kids overpaid and a banker who rejected the deal confirmed it. 

“Is it fair to all concerned?” Rotary’s 4-Way Test

Time for Thinking

s you may know from my email signature, website, the bottom of this newsletter, and elsewhere I have trademarked the term, “The Escape Artist®” for the work we do helping our clients escape their business, their job, or plan for that escape.

But I’m not the real escape artist and I’m not referring to Houdini. I’m referring to the little fuzzball in the picture below. Coco is 10 weeks old and is half Lab and half Siberian Husky. She can escape from almost anywhere. Kid gates, no problem. Backyard gates are now lined with bricks. Furniture barricades, they’ll only slow her down. She seemingly can get anywhere there’s a cord, a backpack, or paper to chew.

I mention this because while her attention span is short and she’s easily distracted, she is super creative. And in today’s world creativity is needed. The same old, same old doesn’t usually work. I don’t consider myself to be very creative. Not like an artist, designer, serial entrepreneur, etc. 

But in today’s world my business has to change. One might say we are “forced” into trying to be of help to our clients in different ways. Creative in finding matches, financing, and deal structures – and in some cases, help our clients survive. There’s no alternative; we, like a lot of companies, have to find new ways to attract customers, deliver our product, etc.

Questions

  • What creativity have you used over the last few months? 
  • Have you brainstormed for new ideas for things not working like they used to? 
  • What happens if you don’t do things differently (out of the box)?

“You have to love a nation that celebrates its independence every July 4th, not with a parade of guns, tanks, and soldiers who file by the White House in a show of strength and muscle, but with family picnics where kids throw Frisbees, the potato salad gets iffy, and the flies die from happiness. You may think you have overeaten, but it is patriotism.” – Erma Bombeck

“The United States is the only country with a known birthday.” – James G. Blaine

Ask the Right Questions; Get the Right Answers

For some interesting early summer reading here are a few things from my buy-sell world. Issues that, for the most part, can be avoided by asking the right questions. However, I can tell you from experience even if you ask the right questions you don’t always get the right answer (meaning what the client really thinks).

Question: (for all owners thinking of selling) “Have you worked with a financial professional to see if the proceeds from the sale are enough for your next great adventure in life?” A deal collapsed when the seller said because of other financial matters in his life he just can’t sell his business now. Believe me, this is not the first time I’ve experienced this, with both my clients and those on the other side of the deal. Plan before you jump.

Question: “What will you do when you sell your business?” I was working on a project involving selling the company to the management team. The owner, a client of at least three other projects, insisted he was prepared to sell. In reality, he wasn’t. He didn’t know what he would do, especially since the answer to the question was not, “Retirement.” He can’t see himself retired. Now, if the answer is retirement, my next question is, “Does your spouse want you around 24/7?”

Question: “Regarding your offer, can you show me your financing package?” A business buyer lost a deal to two other offers that were substantially higher than his offer. Then both other offers couldn’t get the financing together. My constant advise to buyers is, get financing alternatives lined up before making an offer. Another buyer got bank indications of interest before making the offer and it was powerful.

Question: “Have you hit past projections?” There’s a deal lingering because the company (actually the very optimistic seller) can’t seem to ever hit their projections. Another deal was lost recently because the seller insisted on a price based partially on earnings projections for 2019. When those projections turned out to be 25% above the actual earnings the buyer wondered if growth was possible. 

Question: “What are your anticipated capital expenditures?” A business owner is touting the firm’s EBITDA as actual earnings. Yet 25-30% of annual EBITDA is new equipment with an immediate write-off. That’s cash out the door or bank payments over time. It’s a real expense. This is a lot different than when capital expenditures are for a handful of computers and are only 3% of EBITDA. 

To summarize, ask the right questions (usually you’ll get an honest answer), realize how little projections are worth in today’s fast-moving world, get financing lined up before making an offer (on anything, business, home, commercial real estate, etc.), and realize while depreciation used to be a “non-cash” expense, these days it’s probably a real expense in the year assets were purchased.

“The solution to the mystery is always inferior to the mystery itself.” Jorge Luis Borges

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

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.