Recently I spent time with a business owner—let's call him Jack—who runs a 25-person engineering consulting firm. Jack and his partners have been successful, generating more than $1 million in pre-tax profit last year before the owners divided the spoils.
Jack owns half of the shares, and his five partners own the rest. Approaching 60, he is now starting to think about his exit strategy.
Jack was under the assumption that his business would be valuable to an acquirer because of his blue-chip client list, the team he has built and the seven-figure pre-tax profit the company was able to muster.
I think Jack's in for a nasty surprise when he puts his business up for sale. In my experience, the most important thing to an acquirer is the predictability of an ongoing stream of future profit.
As business owners, we're rightly proud of things like our business name, employees, customer list and past financial performance. As a result, we're more inclined to want an acquirer to look at what we have done in the past to value our business. But from what I've seen, acquirers don't really care much about the past. The only reason they even look at past performance is to gauge the extent to which it can be a predictor of future performance.
But the past is a rough indicator at best, so it's the future that acquirers are going to focus on when you go to sell your business. Acquirers pay most for businesses whose future is guaranteed in the form of long-term contracts. After contracts, they will look at your recurring-revenue stream and model out what kind of revenue they can expect based on how frequently your customers have repurchased in the past.
Last and least, they will look at your past financial performance—revenue and profit growth—as a predictor of future results. But if the past is all you have to show for your business, you might be disappointed. Acquirers place a steep discount on businesses when the only way to value them is prior performance.
And this leads us back to my friend Jack who thinks his people, past profits and customer list are assets that will sell. Let's look at why each will be worth little in the eyes of an acquirer:
• People are worth something only if they are very hard to replace and guaranteed to stay. In Jack's case, he has good people, but they are hardly irreplaceable, and any one of them could bolt on three weeks' notice. Even his partners own a relatively small stake in the business—the economic value of which could be matched by an aggressive outfit looking to acquire some senior talent.
• A client list is valuable only if the cost for someone else to acquire those clients is prohibitive. For example, if you wanted to build a large financial planning firm, you might argue it is cheaper to acquire a group of small practices each with 100 customers generating an average of $3,000 a year in fees because, given how fragmented and relatively small each client is, the cost to acquire those 100 customers would be higher than that of buying the practice. However, in Jack's case, his engagements are typically five- and six-figure deals, meaning it would be worthwhile for a potential acquirer (likely a company larger than Jack's) to simply invest in sales resources to acquire Jack's customers, not his business.
• Jack and his team have demonstrated past success through their past financial performance, having generated more than a million dollars in pre-tax profit, and some acquirers may take this as a predictor of future success. But most would argue that success is dependent on Jack and his partners sticking around and, therefore, would offer them a deal with a heavy emphasis on an earn-out. Jack would be trading his equity for a risky job working for a big company—something he hasn't done in 20 years.
My advice to Jack was to stop thinking of his people, client list and past performance as his assets and to start making the future as clear as possible for an acquirer to see. I suggested he create streams of recurring revenue and focus on migrating customers to longer-term contracts, strategies that would help prospective buyers see a stream of profits well into the future—the thing an acquirer cares about most.
John Warrillow is the author of Built To Sell: Creating a Business That Can Thrive Without You, which will be released by Portfolio/Penguin on April 28, 2011.