A client of mine is about to deliver some bad news. The company they want to acquire has no value. Not less value than expected. Not just a little value. Not value that can only be seen with an electron microscope. No value. Zero. Nada. Bupkis. A professional service company that has been around for over a decade in a highly technical and specialized field, with 10 employees, $3+ MM in revenue, has little debt, pays each of its founders over a quarter of a million bucks a year, and even makes a bit of profit above and beyond has no value.
Where did the value go? On the surface, this company should easily have value – millions of dollars of revenue, high-profile clients, a good reputation in the market, and services that are hard to compete with. They even have a pretty decent web site. The answer is that even Sherlock Holmes isn’t going to find the company’s value because the value was likely never there to begin with. The owners think their company has a lot of value. Millions of dollars. Convincing the owners to “sell” isn’t going to be easy. This isn’t telling parents their baby is ugly. It’s telling the parents their baby is really a stuffed platypus and was switched with their real baby at the hospital by accident and nobody noticed until just now, and their real baby is sitting on some platypus eggs somewhere in New Queensland. Sadly, this scenario where company owners are surprised to find they don’t have a business happens frequently. The consequences can be devastating. Families that thought they had created a legacy for their children and employees, or at least a secure and comfortable retirement discover with no recovery time that they have built zero value over a period of years or decades of sacrifice, risk, and hard work. It’s kind of like watching Indiana Jones and the Crystal Skull all the way to the end. Not all companies are meant to be sold. Lots of companies are lifestyle businesses and that’s all the owner wants.(You may not want to change it, and that’s OK, as long as you understand the implications – just as some people prefer dating to marriage, some business people prefer a transient business to one that has a transferable economic foundation.) But if you are working toward a big payday when you’re ready to end the run, you will benefit tremendously from taking steps to ensure that you have something to sell.
Let’s take a step back and think about what identifies a company as an asset. To be an asset, a company must possess the following characteristics:
- The company must consistently earn more for the owners than they could earn with the same effort and expertise if they were working as employees elsewhere (adjusted for the risk assumed as a shareholder);
- The company must earn a return on equity that is greater than could be earned if the retained earnings were invested in an asset of similar risk;
- The company’s key assets (tangible and intangible) must be exploitable to roughly the same level of profitability that they can achieve under the current ownership;
- The company must be able to carry on its operations if the owner(s) were suddenly not available to the company for an extended period of time;
- A new owner can reasonably be expected to continue the company’s operations after a change in ownership; and
- The sale of the company must be legally permissible.
The absence of just one of these features likely excludes the notion that the economic entity in question is, in fact, a true business. In such a case, the company isn’t really a business, but a high-stress job. Businesses can be sold. Jobs generally cannot.
The first five features are indicative of a company that provides financial gain beyond the efforts of the shareholders. The final one is simply a legal constraint that is rare. There is a multiplier effect in which value beyond the company’s annual (monthly? weekly?) cash flow is accumulated. This stored value may not be reflected on the balance sheet. Cash can be distributed, inventory liquidated, accounts receivable collected or factored. Equipment and real estate can be sold. Value arises from the company’s ability to produce profit and growth exogenously from its shareholders’s actions. Value also is created when the return on an asset is greater than the market returns for similar assets with a similar risk profile. Economists and some consultants call this concept “economic value added”, or EVA.
It’s worthwhile diverting to explore the concept of EVA. Let’s say that you invest $100 and are promised $10 in a year, plus your $100 principal. There is a risk of losing the principal, but you also are offered upside in that, if the investment performs better than expected, you will receive a bonus return. You decide the 10% rate of return is worth the risk of making the investment and would be considered “fair”. You don’t think you are being overpaid for the risk you are taking, and you certainly don’t think you are taking on too much risk for the return offered. A year later, your $100 dollar original investment is returned and instead you receive a $10 return. You made your money back at the level offered, but there is no economic value added. In effect, your investment performed on par with expectations. However, let’s say that the investment made $15 instead – a healthy bonus! Let’s say further that you are offered and decide to re-invest that $5 back into the company, hoping for future returns. That $5 is economic value added. To you, as a passive shareholder, you now have a bonus $5 asset that can generate additional return. Over time, economic value added is compounding, just as with other investments, and the impact of EVA is powerful indeed.
Note that profitability is not part of this discussion. Silicon Valley is built on the premise that unprofitable businesses create EVA, and many profitable companies (such as our example) produce no EVA. Silicon Valley companies are extreme in that they actively shun profits in order to build EVA, usually through technology, branding and barriers to entry, but they serve well to illustrate the point.
Profitable firms that are owner-centric frequently build no EVA, even as they often support their owners with very comfortable lifestyles. When an owner or owners hold sway over key areas of the company’s operations, such as sales and customer relationships, technology, supplier relationships, branding, and vendor relationships, no value is injected into the company itself. Profits are great, of course, At some point, every company must earn them, but the mere existence of profit does not mean that the company has value. Succinctly, if every dollar of profit is directly descended from the ownership, then the business has little or even no value. The most frequent culprit of the missing value is captive customer relationships. It’s great when customers say they only want you to solve their important problems – great for the ego, anyway. That same esteem for you personally is also potentially suppressing the business’s value-creating energy. When you can’t turn over the customer relationship to someone else, you have a grounded asset, and an asset that can’t be transferred can’t be sold, except to someone willing to take a flyer by paying a super low-ball price – think pennies on the dollar.
If you find yourself in this situation and you want to change it, so that you are building value, creating something that someone else will pay you for, how do you go about it?
If you don’t have a long time horizon (say 0-3 years) to when you want/need to sell, you need to think about exit structure – heavy earn-outs, seller notes (possibly without recourse), long post-sale employment agreements, or simply joining the acquirer as a senior employee with some kind of deferred compensation plan. At this point, you’re basically looking to get a payment boost for a few extra years in your job – like Phil Jackson’s tenure as GM of the Knicks, except productive. Alternatively, you may want to think about buying a company that does have positive EVA, and integrating your unique value into it (this will be a separate blog post.)
If you have a longer time horizon, here are some steps you can take to transfer value from yourself into your company.
Recognizing whether or not your company is a business or a job is critical to setting proper expectations for an exit, and for meeting your wealth goals. Specific steps will vary from case to case, and you may find it worthwhile to bring in subject matter experts to help set detailed plans. Whatever you do, don’t be surprised. Don’t be the company that receives the bad news.
What else? Do you agree with this framework? Can you offer any other suggestions on how to tell a business from a job? Leave a comment and raise your own SEO profile as well!
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