Thinking about selling your business—eventually? Here’s some advice on how to maximize its value, reduce costs and minimize risks. (P.S. This advice is equally as useful if you’re not selling your business.)
As it turns out, business buyers are looking for the same things as business owners—sound businesses that produce predictable cash flows with quantified risks. (Who wouldn’t want that?) But what makes a “sound” business? A “predictable” cash flow? A “quantified” risk? These are subjective concepts ultimately intended to support the most tangible of outcomes: a factually-derived, cold, hard purchase price.
Because previous performance does not guaranty future results, financial performance is not the only factor helpful in determining a business’s value. Buyers want assurances that past performance is likely to be repeated (and/or improved). So, when valuing a business, buyers want to see tangible proof that the business’s valuable relationships and assets are protected and its risks are quantified (and, where possible, managed). This proof supports the proposition that past financial performance is more likely than not to be repeated or improved and gives buyers something tangible to “put their hands on” in valuing a target business. This proof allays buyers’ natural skepticism and allows corporate sales to be concluded cheaper and faster. So important is this proof that, we submit, creating and maintaining it increases a business’s value—whether or not the business is being sold.
So, what is this “proof”? That depends on the particulars of a given business’s valuable relationships, assets and risks. What are the business’s sources of revenue? Where does its money come from? Upon what assets and properties are the business’s cash flow dependent? What are the risks to that cash flow? To illustrate, let’s apply these principles to a hypothetical manufacturing business.
“Proof”—A Hypothetical Manufacturing Business
Our manufacturer obtains the bulk of its revenue from selling finished goods. What’s necessary for our manufacturer to continue producing cash flows from sales of finished goods? That depends on the particulars of this manufacturer. It could include intangible things like its relationships with customers, vendors and sources of raw materials, and unique manufacturing “know-how” that makes what or how they manufacture more valuable. It could also include physical assets, like its manufacturing facility, particularly if it is strategically located near customers or raw materials, so that it allows the manufacturer to save transportation costs and time, making its prices cheaper and its products faster to deliver than its competitors. The “proof” of these things (both intangible and physical) might include: customer and vendor contracts; proprietary trade secrets, confidential information or even patents supporting unique manufacturing processes; and the deed or lease for its manufacturing facility.
What are the risks to the manufacturer’s continuing cash flows? Again, these depend on the manufacturer’s circumstances. What if the manufacturer is threatened by an infringement lawsuit from a competitor? What if the long-term lease for its manufacturing facility is coming to an end? What if its source of supply for a key raw material is threatened? These things are important for assessing risks to the business’s ability to continue producing its historic cash flows. Proof of these matters would include copies of the infringement lawsuit and the contested patent or other intellectual property upon which such suit is based. It would also include files documenting the status of lease renewals or the search for an alternative location. Lastly, the manufacturer’s current raw material contract for the threatened source of supply would be critical, as would be contracts representing the status of negotiations or agreements to secure alternative sources of supply.
But what if there was no proof or paperwork documenting these relationships, assets or risks? What if the manufacturer relied upon its president’s personal relationships with vendors and suppliers, instead of having contracts with such parties? How would a buyer be able to evaluate the likelihood and strength of continued cash flows based on those relationships? What if the president intends to retire after the business is sold? What if the manufacturer has not filed applications for patents to protect its unique manufacturing processes or taken steps to protect the confidentiality of its trade secrets (making it very easy for another company to use those processes)? What if the manufacturer has not secured written confidentiality obligations from its employees and contractors who are familiar with such matters (and who could take them with them when they leave)? What if there was no written lease for the manufacturing facility, but instead, the lease was based on a “handshake deal” between the manufacturer’s president and the lessor many years ago?
Such a lack of proof supporting valuable relationships and assets and allowing quantification of risks obviously makes cash flows much more difficult to predict. In fact, at some point, gaps in proof might make future cash flow predictions so tentative that a transaction, at any price, might not even be possible. Moreover, even if the business is not being sold, a lack of such proof increases the risk within which the business operates—and its value, even to the current owner.
It’s Time to Determine what “Proof” Your Business Has—and What It Needs
So, what should the prudent company executive do? Our recommendation is to:
- identify the assets, sources of revenue, critical relationships and risks unique to your business; then
- list the sources of “proof” that your business needs to maintain, support and quantify how these are likely to affect future revenues. (Don’t forget your business’s proof of its relationships with its most valuable resource—its employees.)
Once the business has listed the proof that it needs to maintain, it should then:
- identify areas where insufficient or no proof exists and begin documenting those matters to substantiate important relationships and assets;
- evaluate existing sources of proof to make sure they are adequate, up-to-date, organized, and available; and
- create systems allowing these proofs to be accessible, organized and secure.
Going through these procedures will cause the business to focus on those things that generate and maximize your business’s value—whether or not you are currently considering its sale!
Start Today. Some Areas of “Proof” to Consider
Below is an incomplete list of typical relationships, assets and risks that businesses might consider in evaluating their “proofs.” (Apply these to your unique circumstances before settling on the list of “proof” that is most relevant to your business.)
As you can see from this list, there are many things to consider when documenting—and thereby maximizing—proof of your business’s value. What’s important is that the business start developing this proof early and continue to identify where additional proof may be needed or improved.
If you need help identifying, prioritizing, creating, or improving the particular “proofs” for your business, we can help. Contact Scott Harris at Friend, Hudak & Harris, LLP.
Potential “Proofs” for Businesses to Consider
- Customers: contracts with each customer; list of customers lost and added in the past three years; purchasing policies; credit policies; list of unfilled orders; advertising or marketing contracts, programs and materials; and list of major competitors.
- Contracts with Third Parties: subsidiary, partnership or joint venture agreements; “insider” contracts between the business and officers, directors, shareholders and the business’s affiliates[1]; license agreements (both those for licensing of the business’s intellectual property to others, as well as those permitting the business to use intellectual property that it does not own); security agreements, debts, mortgages, collateral pledges, etc.; guarantees by or in favor of the business; installment sales agreements; distribution, sales representative, marketing or supply agreements; letters of intent or agreements relating to the purchase or sale, merger or consolidation of the business or its assets; agreements to purchase equity in other entities; contracts with customers, quotes, purchase orders, invoices and warranty terms; and non-disclosure or non-competition agreements to which the business is a party.
- Products and Services: list of all products or services sold in the past three years or currently under development; tests, evaluations and other data regarding existing or developmental products or services; descriptions of all products and services, correspondence, applications and reports relating to regulatory application and approval for products and services; and descriptions of all complaints and warranty claims.
- Legal Matters: articles of incorporation or organization and all amendments; bylaws and amendments; voting agreements; shareholder and/or operating agreements (whichever is applicable for the particular entity); stock ledgers and certificates, subscription agreements and shareholder lists; stock option, stock purchase plans and grant or award agreements under each; puts, calls, warrants, subscriptions and convertible securities; minutes of director, director committee and shareholder meetings (both annual and special meetings); certificates of authority to conduct business as an out-of-state company or LLC; list of all states and countries where the business has employees, property (whether owned or leased) and conducts business; annual company reports filed in each state; and list of all trade names and registrations for fictitious names.
- Financial Information: last three to five years’ year-end balance sheets, income statements, statements of changes of financial position (whether audited or not); auditor’s and CPA’s letters and responses; most recent interim financial statements; list of all debts (both long- and short-term); credit reports; general ledger accounts; descriptions of internal control policies; and projections, budgets and strategic plans.
- Real Property: list of all business locations; deeds; mortgages; leases (including renewals); title insurance policies; surveys; and zoning approvals, variances and use permits.
- Personal Property: lists of all personal property of the business, describing the property, its type, location, and date of acquisition; motor vehicle registrations; all property leases, including vehicles; and list of capital equipment purchased or sold in the past three years.
- Intellectual Property: lists of patents, copyrights, trademarks and service marks, and all registrations for same; list of trade secrets and confidential information of the business; any agreements or other documentation evidencing the business’s ownership of, or rights in, such intellectual property.
- Employee and Consultants: employee lists with name, address, last three years’ salary and bonus, title, position description, initial employment date, and years of service; employment agreements; consulting agreements; non-disclosure, non-solicitation and non-compete agreements; invention disclosure and intellectual property assignment agreements; separation agreements; employee handbooks; lists of accrued holiday, vacation and sick day leave; employee benefit plans and their descriptions; workers’ compensation claims and history; discrimination, grievances, harassment, labor disputes, requests for arbitration, workers’ compensation, unemployment, and wrongful termination claims and history; list of all employee benefits plans, summary plan documents and descriptions of qualified and non-qualified plans; list and description of all health, welfare and disability insurance policies and self-funded plans; and collective bargaining agreements.
- Licenses & Permits: business licenses; any governmental approvals, consents or permits; and copies of applications to, or proceedings before, regulatory agencies.
- Environmental: for each property ever owned or occupied: environmental audits, list of hazardous substances, environmental permits and licenses; property owned or occupied; and lists describing all environmental litigation, investigations, liabilities or continuing indemnification obligations.
- Taxes: copies of all foreign, federal, state, and local tax reports and returns for the last three to five years; sales and use tax returns; audit or revenue agency reports; tax settlement documents; employment tax filings; and tax liens.
- Claims and Litigation: a description of any pending or threatened litigation; copies of insurance policies possibly providing coverage as to pending or threatened litigation; all documents relating to any injunctions, consent decrees, or settlements to which the business is a party; and list of any unsatisfied judgments.
- Insurance: list and copies of the business’s general liability, personal and real property, product liability, errors and omissions, key-man, directors and officers, worker’s compensation, and other insurance policies; and list of insurance claims history for past three years.
[1] Which means any person or entity, controlling, controlled by, or under common control with, the company.
