Financial Advisors – It's Time for Some Difficult Discussions with Your Business Owner Clients

If this recent market meltdown has taught us anything it is to make sure you are diversified over several investments and asset classes. Would you recommend that a client put 80% or more of their assets into a single investment? Of course not, but a large percentage of your clients actually have that level of concentration. Your clients that are business owners likely have 80% or more of their family's net worth tied up in their business. On top of that, privately held businesses are illiquid assets often requiring one to two years to sell. So for your baby boomer business owner clients, it is time to have some tough discussions. It is time to move your financial advisory practice beyond the scope of a provider of financial products to an advisor on family wealth maximization solutions.

Business owners are typically not proactive when it comes to exit planning or succession planning in their business because it forces them to embrace their own mortality. Well, they just need to get over it. If an owner has a sudden debilitating health issue or unexpectedly dies, instead of getting full value for the company, his estate can sell it out of bankruptcy two years later for ten cents on the dollar. This is a punishing financial result for the lack of appropriate planning.

Statistics on Business Exits

• According to Federal Reserve's Survey of Consumer Finances, in 2001, 50,000 businesses changed hands. That number rose to 350,000 in 2005 and is projected to increase to 1,000,000 by 20015. Some estimates place the value of businesses transitioning to new leadership over the next ten years at $10 TRILLION. The Price Waterhouse Trendsetter Barometer Survey shows that nearly 65% of CEO's plan to retire within ten years or less: 
• 42% within 5 years.  51% of those plan on selling to another company while 18% plan on a transition to family members and another 14% plan on a management buyout.

·         Only 22% have done a great deal of succession planning and another 26% have done some. But 24% have done little, and 19%, virtually none.  9% did not report.

·         Only 39% percent of CEO's have a likely successor in mind, but less than two-thirds of them say that person is ready to take control today. 

But among those planning to sell their business, far fewer have explored the following opportunities:

·         Only 36% have planned how to increase after-tax proceeds;

·         Only 35% have developed an investment strategy to protect and manage their monetized wealth

Questions You Should Be Asking of Your Business Owner Clients

In your role of providing a holistic approach to maximizing your client's wealth, you should be asking these questions:

       What are your plans for your business when you retire?

·         Do you have children that you want to take over the business?

·         Have you determined how you are going to transfer the ownership?

·         Do you know how much your company is worth?

·         What % of your family's net worth is in your business?

·         In your business life, what keeps you up at night?

·         If you were hit by a bus tomorrow, God forbid, what would happen to
your business?

In your role of trusted advisor, you simply must ask these difficult questions and guide your client in exploring options and planning for his eventual exit. Before he just assumes that the  torch will be carried by the next generation, make sure that the next generation even wants to run the business.  Imagine the loss in value that would have occurred if the real estate billionaire from the western suburbs of Chicago had turned his empire over to his son who simply wanted to produce plays.

Are his heirs even capable of running the business?  Has he held on to the reins so tightly that the kids involved in the business have not been able to develop their decision-making or leadership skills?  Do they command company respect because of their personal strength and skills or are they grudgingly granted respect because they are the child of the owner?  If that is the case, the odds are not good for them taking over when he retires.

The business owner must make some difficult decisions when he or she decides it is time to retire. Why did he create this business?  Was it to keep this business in the family for generations or was it to provide for his family for generations?  If the desire and the capability of the children are not evident and the company is large enough, it may be the right decision to first get outside board members actively involved as step one.  Step two would be to hire professional management to run the business. A second alternative is to sell the company while he is still running it and it can command its highest value. If he has children that want to remain in the business for the immediate future, incorporate that into the sale agreement with employment contracts.
Another way to ask your client to think of it is, while I am running the business, the best ROI is to keep the bulk of my net worth invested in this company.  If I am no longer running the company what is the best risk reward profile for my net worth?  Would my heirs be better off if the business was sold and the value converted to financial assets?

Many financial advisors feel uncomfortable having these types of discussions with their clients. Because of the business owner's reluctance to plan for his business exit, you should actively get out in front of the process with your client. This decision and how it is executed will be the single most impactful event in your client's financial future. You can take on the quarterback position in assembling a multidisciplinary team that can include:

The Financial Advisor – Coordinate all the pieces for a holistic wealth maximization plan

Attorney – Create the necessary documents, wills, trusts, family LLC's, corporate structure, etc.

Estate Planner – work with financial advisor and attorney to create the properly documented estate roadmap

CPA/Tax Advisor – review corporate structure, analyze after tax proceeds comparison of various transaction structures, create tax deferral and tax avoidance strategies

Investment Banker/Merger and Acquisition Advisor – Analyze the business, create value creation strategies, position the company for sale, and create a soft auction of multiple buyers to maximize selling price and terms.

As your business owner clients approach retirement, you need to help them with investment decisions that employ sound diversification and liquidity strategies. Their business is generally the largest, most illiquid, and most risky investment in their total wealth portfolio. Their successful business exit should be executed with the same diligence, knowledge, experience and skill that you regularly apply to their other asset class decisions.

Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital

Sell Your Information Technology Company -Why Pay an Investment Banker?

Perhaps the most important transaction you will ever pursue is the sale of your business. Many owners of information technology companies attempt to do it themselves and often times these very capable business people approach the sale of their business with less formality than in the sale of a home. The purpose of this article is to answer the questions - Why would I use an investment banker and what am I getting for the fees I will pay?

More than any other type of business sale, the intellectual property based business is the most complex and difficult. The primary reason is that the seller is not interested in selling their company for a financial multiple like 5 X EBITDA. They almost always want that amount plus a premium for strategic value. Another very important factor is that most smaller information technology companies run their financials on a cash basis and the buyers usually employ the accrual method. The adjustments in transaction value that often occur during the due diligence process are often surprising and expensive. Below are several reasons why a seller of an IT business should seek a firm that specializes in this type of business sale.

1. Confidentiality. If an owner tries to sell his own business, that process alone reveals to the world that his business is for sale. Employees, customers, suppliers, and bankers all get nervous and competitors get predatory. The investment banker protects the identity of the company he represents for sale with a process designed to contact only owner approved buyers with a blind profile - a document describing the company without revealing its identity. In order for the buyer to gain access to any sensitive information he must sign a confidentiality agreement. That generally eliminates the tire kickers and deters behaviors detrimental to the seller’s business

2. Business Continuity. Selling a business is a full time job. The business owner is already performing multiple functions instrumental to the success of his business. By taking on the load of selling his business, many of those essential functions will get less attention, sometimes causing irreparable damage to the business. The owner must maintain focus on running his business at its full potential while it is being sold.

3. Time to Close. Since the investment banker's function is to sell the business, he has a much better chance of closing a transaction faster than the owner. The faster the sale, the lower the risk of business erosion, customer defection, employee problems and predatory competition.

4. Large Universe of Buyers. The investment banking firm that specializes in information technology and software companies already has a developed list of target companies with contact information for the individual that runs the merger and acquisition process. They recognize that information technology companies with the same SIC Code 5734-01 can be vastly different and need a further categorization like document management software, SaaS CRM Systems, or healthcare financial software.

5. Marketing. A merger and acquisition advisor can help present the business in its best light to maximize selling price. He understands how to recast financials to recognize the EBITDA potential post acquisition.  He understands the key value drivers for buyers and can position the selling company to enhance its strategic value in the eyes of the buyer.

6. Valuation Knowledge. The value of a business is far more difficult to ascertain than the value of a house. Every business is unique and has hundreds of variables that effect value. This is especially true with companies with a strong component of intellectual property. Investment Bankers have access to business transaction databases, but those should be used as guidelines or reference points. The best way for a business owner to truly feel comfortable that he got the best deal is to have several strategic industry buyers bidding for his business. An industry database may indicate the value of your business based on certain valuation multiples, but the market provides the real answer.

7. Balance of Experience. Most corporate buyers have acquired multiple businesses while sellers usually have only one sale. In one situation we represented a first-time seller being pursued by a buyer with 26 previous acquisitions. Buyers want the lowest price and the most favorable terms. The inexperienced seller will be negotiating in the dark. To every term and condition in the buyer’s favor the buyer will respond with, “that is standard practice” or “that is the market” or “this is how we did it in ten other deals.”  Our firm has saved our clients transaction value greater than our total fees during the due diligence and closing adjustments process.  By engaging an investment banker that specializes in information technology companies, the seller has an advocate with an experience base to help preserve the seller’s transaction value and deal structure.

8. Maximize the Value of Seller’s Outside Professionals. Experienced investment bankers can save the seller significantly on professional hourly fees by managing several important functions leading up to contract. His compensation is usually comprised of a reasonable monthly fee plus a success fee that is a percentage of the transaction value. The M&A advisor and seller negotiate with the buyer the business terms of the transaction (sale price, down payment, seller financing, etc.) prior to turning the purchase agreement over to outside counsel for legal review. In the absence of the investment banker, that sometimes-exhaustive negotiation process would default to the outside attorney. The economics of the deal are not your attorney's area of expertise and could result in significant hourly fees or even a breakdown of the transaction.

9. Maintain Buyer - Seller Relationship. The sale of a business is an emotional process and can become contentious. The investment banker acts as a buffer between the buyer and seller. This not only improves the likelihood of the transaction closing, but helps preserve a healthy buyer - seller relationship post closing. Often buyers want sellers to have a portion of their transaction value contingent on the successful performance of the company post closing. Buyer and seller need to be on the same team after closing.

Our experiences with information technology companies that engaged our firm as a result of an unsolicited offer from a buyer have been quite instructive. The eventual selling price averaged over 30% higher than the first offer. In no case was the business sold at the initial price.

The technology focused investment banker helps reduce the risk of business erosion with improved confidentiality while allowing the owner to focus on running the business. The advisor- led sale helps maximize sales proceeds by involving a large universe of qualified and targeted buyers in a competitive bidding process. Finally, the investment banker can improve the likelihood that the sale closes by buffering buyer - seller negotiations and by balancing the experience scales.

Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital

Taking Your Information Technology Company to the Next Level - It Could Be Time to Sell

Thinking of taking your information technology company to the next level with a major capital investment or hiring additional sales resources? These are decisions that can impact your company's future. It might be time to consider the alternative of selling your business.
We are often approached by information technology company owners at a crossroads of taking the company to the next level. The decision in most cases is whether they should bring on the one or two hot shot sales people or channel development people necessary to bring the company sales to a level that will allow the company to reach critical mass. For a smaller company with sales below $5 million this can be a critical decision.

For frame of reference, prior to embarking on my merger and acquisition advisor career, I spent my prior 20 years in various sales capacities in primarily information technology and computer industry related companies from bag carrying salesman to district, regional, to national sales manager and finally Chief Marketing Officer. So when I look at a company, it is from the sales and marketing perspective first and foremost. I am sure that if I had a public accounting background, I would look at my clients through those lenses.

So with that backdrop, let's look at what might be a typical situation. The company is doing $3.5 million in sales, has a good group of loyal customers, produces a nice income for its owner or owners, and has a lot more potential for sales growth in the opinion of the owner. Some light bulb has been lit that suggests that they need to step this up to the next level after relying on word of mouth and the passion and energy of the owner to get to this stage.

I have either spoken with more than 30, primarily information technology based companies over the years that have faced this exact situation and can count on one hand the ones that had a successful outcome. The natural inclination is to bite the bullet and bring on that expensive resource and hope your staff can keep up with the big influx of orders. The reality is that in most cases the execution was a very expensive failure. Below are several factors that you should consider when you are at this crossroads:

1.    The 80 20 rule of salesmen. You know this one. 80% of sales are produced by 20% of the salespeople. If you are only hiring one or two, the likelihood is that you will not get a top performer.

2.    The founder of the company is a technology guy and has no sales background, so the odds of him making the right hiring decision are greatly diminished. He will not understand how to properly set milestones, judge progress, evaluate performance objectively, or coach the new hire.

3.    To hire a good salesman that can handle a complex sale requires a base salary and a draw for at least 6 months that puts him in a better economic condition than he was in on his last job. So you are probably looking at $150,000 annual run rate for a decent candidate.

4.    If you have not had a formalized sales effort before, you are probably lacking the sales infrastructure that your new hire is used to. Proper contact management systems, customer and prospect databases, developed collateral materials and sales presentations, sales cycle timeframes and critical milestones and developed competition feature benefit matrixes will need to be developed.

5.    Current customers are most likely the early adapters, risk takers, pioneers, etc. and are not afraid of making the buying decision with a small more risky company. These early adaptors, however, are not viewed as good references for the more conservative majority that needs the security of a big company backing their product selection decision.

6.    Your new hire is most likely someone that came from a bigger company like IBM or Oracle and may be comfortable performing in an established sales department. It is the rare salesman that can transform from that environment to a new role of developing the sales infrastructure while trying to meet a sales quota.

7.    Throw on top of that the objection that he has never had to deal with before, the small company risk factor, and the odds of success diminish. When he was hired he assured you that he would bring his very productive address book and deliver all of these customers from his Blue Chip prior employer. He and you soon discover that he may not have been totally responsible for his sales success. Having IBM or Oracle on his business card may have been the predominant success factor.

8.    Finally, this transformation from a core group of early adapters to now selling to the conservative majority elongates the sales cycle by 25% to as much as twice his prior experience. If you don't fire him first, he will probably quit when his draw runs out.

With all this going against the business owner, most of them go ahead and make the hire and then I hear something like this, "Yes, we brought on a sales guy two years ago who said he had all the industry contacts and in nine months after he hadn't sold a thing and cost us a lot of money, we fired him. That really hurt the company and we have just now recovered. We won't do that again."

What are the alternatives? Certainly strategic alliances, channel partnerships, value added resellers are options, but again the success rate for these arrangements are suspect without the sales background in the executive suite. A lower risk approach is to outsource your VP of Sales or Chief Marketing Officer function. There are a number of highly experienced and talented free lancers that you can hire on a consulting basis that can help you establish a sales and marketing infrastructure and guide you through the staffing process. That may be the best way to go.

An option that one of our clients chose when faced with the eight points to consider from above was to sell his company. This is a very difficult decision for an entrepreneur who by nature is very optimistic about the future and feels like he can clear any hurdle. This client had no sales background but was a very smart subject matter expert with an outstanding background as a former consultant with a Big 5 accounting firm.

 He did not make the hiring mistake, but instead went the outsourcing of VP of Sales function as step 1. When their firm wanted to make the transition from the early adapters to the conservative majority, the sales cycle slowed to a crawl. Meanwhile their technology advantage was being eroded by a well funded venture backed competitor that had struck an alliance with a big vendor.

We were able to find him the right buyer.  His effective sales force has been increased from one (himself) to 27 reps. His install base has been increased from 14 to 800. Every one of the buyers current customers is a candidate for this product. The small company risk has been removed going from a little known start-up with $1 million in revenues to a well known industry player, publicly traded stock with a market cap of $2.5 billion.

A portion of his transaction value was based on post acquisition sales performance, and things worked out very well.

He avoided the big cash drain that a bad sales person hiring decision would have created and he sold his company before a competitor dominated the market and made his technology irrelevant and of minimal value.

My professional contacts sometimes tease me and suggest that I think every company should be sold. That may be a slight exaggeration, but in many instances, a company sale is the best route. When a business owner is faced with that crossroads decision of bringing on a significant sales resource that will be faced with a complex sale and the executive suite does not have the sales background, a company sale may be the best outcome.
Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital

Software Company Valuation - Theory Versus Market Reality

Business valuations of software companies use proven methodologies to arrive at an indication of value. If the technology is one in demand, however, the valuations provided by the markets can be off the charts. This article discusses how the pros value software companies and the limitations to their approach.
Software company owners looking to sell their companies are often inspired to start the process after reading about the latest high profile, stratospheric acquisition price paid by a large tech bell weather company. The transaction metrics, i.e. transaction value to sales or transaction value to EBIT sometimes defy all logic.

The new, would-be seller applies these metrics to his company's sales and EBIT and determines that IBM, Microsoft, Google, Oracle, Cisco, etc. should be ready to get into a bidding war over his $5 million in revenue, game changing, best in breed software company for a value of 8 X revenue.

Let's break down the methodology that professional business valuation firms use as their standard in arriving at a company's indicated value. Their approach calls for a triangulation of three valuation methodologies.

The first is a comparison to publicly traded companies in the same category. It is very interesting to look at the lists that the valuators come up with. Technically they are all software companies with SIC Code 5734-01, but they are as alike as apples, coconuts, watermelons, and blueberries. True, they are all fruit, but that is where the similarity ends.

Next, they take the valuation metrics of these publicly traded companies. The most commonly used are sales to enterprise value and EBIT to enterprise value. Next they come up with the median value (one half of the companies are above the value and one half are below). They then apply what I can best describe as an arbitrary discount factor to account for the value differential between public companies and small, closely held companies. They come up with their adjusted metrics then apply them to the target company and voila, you have one of the valuation legs completed.

The valuation analyst next applies the same approach to actual completed transactions. If the buyer was a public company then the metrics are publicly available. If the transaction is between two privately held companies, the metrics are only available on a voluntary basis. Maybe 10% of these participants release information about these transactions. These unreported deals are probably the best fit in terms of comparables.

In order to get a meaningful number of transactions, the analyst often is forced to use transactions from a 5-10 year period. Do you know how to say Tech Bubble/Tech Meltdown? Wow, this isn't sounding quite as scientific as I originally thought.

Wait, maybe we can add some needed precision with the third valuation technique, the discounted cash flow method. My Wharton Finance Professor would be so proud. First they calculate a risk adjusted discount rate. After three pages of explanation, they usually arrive at a discount rate of between 24-30%. They next project the after tax cash flow for the next five years and discount it to present value.

They then calculate the terminal value of the company (five years of year five cash flow discounted by the risk adjusted rate less the projected growth rate). They discount that number to present value and add that to the discounted cash flow to create the third leg of the valuation stool.

How many software companies are not projecting hockey stick growth during the valuation period in question? Not only are these projections very aggressive, but cash flow margins are projected to improve by a factor of three times during this same period.

Now our seller is armed and dangerous with his company's value. That becomes his minimal acceptable offer and it must all be in cash at closing. To use a Wall Street term - this company is priced for perfection. We often discover during a sell-side engagement that these projections are not just missed, but they are missed by a large margin. In spite of this, the seller's valuation expectations remain the same.

All is not lost, however. One of the unique aspects of selling a software company is that if the technology is fresh (think SaaS, Mobile Apps, Virtualization, Cloud Computing) financial multiples are often not the driving force in the buyer's valuation equation.

One thing that we have learned in the representation of software companies for sale is that the value is subject to broad interpretation by the market. We find that strategic buyers in this space are driven by such considerations as first mover advantage, time to market, development costs, customer acquisition costs, customer defections, and enhancing an existing product suite.

The better the target company addresses these issues, the greater the post acquisition value creation potential. If the right buyer is located and recognizes the seller's potential when integrated with the new owner's distribution channel and customer base, we may find an even bigger hockey stick then our very optimistic sellers. If two or three buyers recognize a similar dynamic, then the valuations can become very exciting.
Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital