The Negative Effects of Owner Dependence On Business Valuation and the Sale Process, and Steps You Can Take To Mitigate Them.
“A business that can’t run without its owner is a business with a deadline.” – Guy Rigby (2012)
by Max Friar
The purpose of this article is to show the detrimental effects of owner dependence – a business’ reliance on the owner for the functioning of day-to-day operations – on the valuation of small business, especially when the owner decides, or needs, to sell to an unrelated third party.
Both academic and non-academic research regarding mergers and acquisitions of small businesses demonstrate that owner dependence is one of the more important factors in valuation and marketability of these businesses. It is, however, one of the most difficult factors to quantify primarily because of the varying perceptions of risk by different buyers. It’s also important to realize that much of the value in an owner-dependent business is destroyed when the owners depart abruptly, whether this is due to illness or a planned sale of the business. Unfortunately, many business owners envision a breezy transition to retirement in which they simply hand the keys over and their buyer will deal blithely with all of the risks that the future holds. In fact, according to a recent Forbes.com online poll, almost one-third of respondents said “I expect to sell my business to a new owner.” Sadly, this expectation doesn’t match reality. The business brokerage industry reports that the success rate for selling a small business is approximately 20%. That means one in five of those who want to sell will actually succeed in selling their businesses.
Why Do So Few Business Owners Who Want To Sell Actually Sell?
There is not one particular reason; however, in my experience the reason most owners who want to sell are unsuccessful is because their business is classified as a “knowledge-intensive firm” (KIF) and they have not put in place any mechanism to transfer that necessary knowledge to a buyer. Typically when people think of a KIF, they think of businesses that require intensive training to establish, such as law firms or accounting practices. However, in most small businesses with fewer than twenty employees, there exists an enormous amount of unwritten, uncodified knowledge that resides in the minds of the owners and key managers. This unwritten knowledge isn’t simply related to business processes – it extends to sales, customer relationships, employee relationships, culture, autonomy, training and many other aspects. Essentially the value of a KIF is human capital as opposed to land, monetary or other physical capital. The competitive advantage of these companies is gained by converting the knowledge and skills of those owners or individuals into intellectual capital (Gurbanov 2013). The yield of that intellectual capital is customers, relationships and sales. Therefore, if there is no assured way that the intellectual capital can be transferred, the price, marketability and deal structure during a sale will be negatively affected due to increased risk perception by the buyer. The business simply isn’t worth as much without the owner and key personnel.
Again, the value of intellectual capital is not just confined to KIFs, but to any business in which the owner or key personnel hold intangible knowledge and experience that are critical to the survival of the company. Examples would include:
a contracting business if the owner has a team of installers/builders, but does all of the design and quoting himself
a machining company with a staff of five workers, but an owner who handles all sales calls and relationships
a design business with a team of graphic designers, but an owner who manages all of the client meetings, planning, billing and final approval of projects.
This is not to say that there is not value in these companies, or that buyers do not exist for them. They do. These kinds of businesses sell every day, but the values and deal structures are not maximized for the owners. Bluntly, the sellers do not get the price or deal structure that they want largely due to items that are in their control; they have not done what they could have during their tenure to mitigate perceived risk! The more you can do as an owner to mitigate risk with regard to the transfer of your business, the more valuable and marketable your company will be. I get more specific below.
I believe an additional reason for the persistent continued imbalance between owners’ expectations and the reality of a transaction is due to the way, culturally, that business owners are educated about valuation. When consulted, a business appraiser will essentially take a snapshot of a business at a given point in time and deliver an indicated value in terms of a set dollar amount based on theoretical valuation models. This is certainly valuable information to a seller, but it does does nothing to impart, in terminology that an owner can understand, how a real buyer is going to determine the value of their business. Unfortunately, as a result, owners often believe that they will be able to take their specific price expectation to market, and a buyer will come forward, cut them a check and the rest is history.
That is not the case. In fact, in most situations in which the owner is critical to the day-to-day functioning of the business, the owner may receive a down payment for the value of the business’s assets and be compelled to take the rest in a seller note, or – worst of all – an earn-out based on future performance. Conversely, in situations where owners have well documented business processes, employ a stable management team, and take steps to remove themselves from the necessity of their personal day-to-day oversight of the business, buyers line up down the street ready to overpay with cash and get the transaction wrapped up as soon as possible. I have documented examples here and here of how this played out recently in two successful business sales.
So, How Exactly Does Owner Dependence Affect The Sale Process?
So now let’s get specific by briefly exploring each metric of the sale process to better understand how and why the sale process is affected negatively:
Price: Educated buyers will evaluate the potential effect of the absence of the owner or other key personnel. This will typically include an analysis of how future sales and relationships may or may not transfer. The buyer will then apply this risk to the valuation model meaning that they will adjust future earnings, or the earnings multiple applied downward, thus negatively affecting the price.
Marketability: If buyers are uncertain about a business’s quality, transferability and synergies due to heavy owner involvement, it will take them longer to properly evaluate the company in terms of transition plan, fit, and valuation. Additionally, unlike in sales of owner-independent businesses, every buyer will view risk factors differently along a wider continuum. What may seem to be a negligible risk to one buyer will be unmanageable risk to another; risk perception cannot always be predicted. These factors combined reduce the ability of an intermediary to run a tight limited-auction sales process. Fully evaluating the complexity of the business for sale inherently slows down the process and does not allow for the elements of a sale process to align in a fashion that maximizes price by leveraging multiple buyers against each other. Lastly, many high quality buyers will simply look past the opportunity for one that does not present so many transferability questions.
Structure: The way that buyers compensate for risk is via deal structure. If a buyer is concerned about quality, transferability and synergies, they will likely offer a lower price and/or terms that cause the seller to assume significant risk. For example, if buyer and seller agree on a valuation of $300,000, instead of a one-time cash payout, the buyer may offer $150,000 cash at closing, a $100,000 seller note at 5% and an earn-out of $50,000 based on future revenue. The buyer does so as a way to share risk in entering a situation where the outcome is far from assured and to ensure that the owner will do all he or she can to make the transition run seamlessly.
So, what are some things to consider in moving towards a sale process that will yield the highest price, best terms and least amount of time?
Actions Owners Can Takes Today To Improve Their Outcomes In a Future Sale
In a 2013 research paper, Adil Gurbanov of the University of Twente attempts to define a framework for understanding valuation gaps in owner-dependent versus owner-independent businesses. In doing so he laid out a very interesting and simple model to understand and guide owners to a framework that increases the value, marketability and autonomy of their company. I will explore each of those topics and give my personal thoughts on them having experienced business sales across a wide spectrum of owner-preparedness.
Let’s look at the problems and solutions together:
Problem: A company’s client base consists of contacts from the owner’s personal network, with a high concentration of a few customers and a perceived high level of difficulty transitioning these relationships due to heavy owner involvement/history. Typically the buyer is going to ask, “Are these customers going to work with me?” If the owner cannot demonstrate reasonably that they will, the deal structure will likely be modified to entice the owner to work hard at transferring these relationships after the sale.
Solution: First, the business works to grow a brand name. This is accomplished over time and by overt marketing efforts in the region in which the company sells. Having an established brand makes new sales less reliant on the owner’s personality.
Second, the owner undertakes continued sales efforts to reduce customer concentration. Yes, it is easier for an owner to manage one or two large, profitable relationships; however, when they prepare to sell, any potential buyer will see one or two red flags waving brightly. Many owners are proud that they do not spend money on marketing; however, this typically means that they will have to sell for less than the business’s current value and have put a transition at risk as well.
Third, the owner transfers the management of clients and customers to other reliable staff. Over time, the owner can explain to customers that their primary role is strategic growth and planning. Introducing clients to a project manager and letting them know that the owner is available to them – but only if necessary – is a vital step towards owner independence.
Problem: The business has a lack of delegation or ineffective or unstable management. Business owners will assert: “I must oversee everything in order to make sure there are no problems for customers. Yes, I’m exhausted and have no personal life, but at least everything is under my thumb.”. This philosophy may work for an energetic sole proprietor during the company’s initial years, but it is not a recipe for business success, longevity or continuity.
Solution: The first step is finding competent employees and delegating to them. This can be extremely difficult and emotional for many owners, but it is absolutely critical. The E-Myth by Michael Gerber is a very helpful resource for owners to consult in order to understand how take the steps necessary to grow a company beyond one person.
The second step is to institutionalize your knowledge into the business, via both its employees and documentation.
Problem: The company lacks an effective manager who will remain with the company after its sale, and who has the operational autonomy necessary to remain engaged and effective.
Solution: Many leading management resources indicate that allowing employees’ autonomy within a set of standards and company goals is the best way to manage. A Cornell study of 320 small businesses divided their subjects into two groups – employees operating under traditional management, and employees allowed more autonomy and decision making. Over time the companies with autonomous employees grew at four times the rate as those with traditional management and lost workers at one-third of the rate. It is crucial, of course, to hire or promote competent, trustworthy people, but utilizing a less controlling management style with them can be a very successful approach toward building and maintaining a business’s value. Conversely, micromanaging a competent staff reduces both retention and innovation.
Problem: The owner runs his business in his or her head with no recorded business processes.
Solution: Creating a manual, even just a narrative, of how a business works, is an enormous asset in a sales transition. Specifically address how sales are obtained, how work is outlined and conducted, how billing is handled, how employees are hired, reviewed, and fired. Any gaps in formalized processes should be stated and acknowledged.
Also, create and implement written policies and procedures. Often larger companies will outline these policies and procedures on their websites, providing a quick resource so that small business owners need not spend months creating them from scratch. A lack of specific operational policies and procedures is a negative during a sale process.
These are just a few high-level problems and proposed solutions based on my personal experience in mergers & acquisitions. I am not pretending that making your business owner-independent is by any measure an easy process. It takes dedication, a plan, and the ultimate risk of trusting your name and legacy to the management of someone else. In fact, I often meet owners that simply cannot fathom stepping aside and letting others run their business. It’s a very strong psychological barrier to overcome.
The purpose of this article is to demonstrate that the risk associated with owner dependency, whether real or perceived by a buyer, affects business value, marketability and deal structure negatively for the seller. Taking slow, small steps towards owner independence can dramatically decrease buyer risk perception, thus increasing value, marketability, deal structure and speed to the closing table.
Calder Capital is working on a framework that will help to define more precisely how each of the softer elements of the intellectual capital affects deal structure, marketability and valuation.
If you would like Calder Capital to review your business and give you a no-cost, no-obligation value and marketability assessment, please contact us.
Max Friar is Managing Partner of Calder Capital, LLC, a Grand Rapids, MI-based mergers and acquisitions firm. Max is passionate about helping to educate and guide business owners about and through the business-for-sale process. He specializes in transactions ranging in size from $500,000 to $5,000,000. Max lives in Grand Rapids with his three children, Brenna, Max and Jack.