by Norm Brodsky
Understand, this is a rough, down-and-dirty formula. Some people might say it makes a number of dubious assumptions—for instance, that you pay al your own bil s at once. But forecasting is inexact by definition. You need some simple tools to guide you. This one al ows you to make a reasonable guess about your future cash needs, and it errs on the side of caution, which is always a good idea.
What do you do with the information? You obviously aren’t going to turn away good, high-margin business. So you look for ways to generate the additional cash. Maybe you can reduce the col ection days on your current accounts. Maybe you can extend your payables by a week or two. Maybe you can make a deal with the new customers to get paid more quickly than usual. Or maybe you go to your major vendors and say, “Listen, I have great news for both of us. I just landed a new account that’s going to bring in a lot more business, but I’l have to pay you in sixty days rather than forty. Can you handle that?” There are very few vendors who would say no.
As a last resort, you can always borrow the money, if you don’t mind increasing your bank debt and adding to your costs. Then again, you may decide it’s better to go without a salary for a few weeks. I myself haven’t had to take that route in recent years and would prefer to avoid it in the future. I’m sure my wife feels the same way. She likes it when I get paid every week. So do I, for that matter. It gives us both a sense of being in control. In business, you can’t be in control if you aren’t on top of your cash flow. That’s a lesson worth learning as early as possible.
Ask Norm
Dear Norm:
I’m an entertainer and a tennis professional with a sports-education business, teaching tennis through on-court musical tennis shows and specialty clinics. I want to grow the company, and I have the passion and the long-term vision to do it, but I don’t have a business background. Do I have time to become a businessman, or do I need to find people to grow the business for me?
David
Dear David:
My guess is that you have many more business skil s than you give yourself credit for. You have customers, don’t you? You must have sel ing ability and marketing ability, and those are two of the most important skil s a businessperson can have. OK, so you may not know accounting.
That doesn’t mean you can’t learn the numbers, and it’s the numbers you need to know, not the technicalities of accounting. My advice is to go ahead. There’s only way to acquire business experience: you have go out there and take your lumps. You can’t succeed without trying. At worst, you’l get a great education for your next business.
—Norm
The Ultimate Prize
In the end, of course, the payoff for building a business is the reward you get when you sel it. Unfortunately, many business owners miss out on that reward—or a big part of it—because they don’t understand the factors that go into calculating it and don’t keep the financial records that would al ow them to get ful value for what they’ve created. But that doesn’t stop them from having grossly inflated notions of what their companies are worth.
The companies on Inc. magazine’s annual list of the 500 fastest-growing private companies are prime examples. I’ve looked at some of the applications they submit. I remember one that had lost money on sales of about $60 mil ion the previous year, and yet its owners thought it was worth between $50 mil ion and $100 mil ion. Evidently, they hadn’t heard what happened to al those profitless Internet companies of the 1990s.
Another company had a net profit of less than $335,000 on sales of about $6.5 mil ion—which doesn’t explain how the owners came to believe it was worth between $100 mil ion and $200 mil ion. In fact, I’d say that about half of the companies I’ve looked at reported absurdly high valuations.
The rest were just extremely high.
I can easily understand how Inc. 500 CEOs, and former Inc. 500 CEOs, get such ideas. As a group, after al , we tend to have fairly large egos, which isn’t entirely bad. You need one to grow a business fast enough to make the list. But our egos can get us in trouble when putting a dol ar value on our businesses. We general y take the highest valuation we’ve heard of for a company somewhat like ours—and multiply it.
But it’s not just the fast growers who think their companies are worth much more than they are. Consider a deal that was brought to my attention by my former partners in the document destruction business, Bob and Trace Feinstein. They’d heard about a smal er company that was looking to be acquired. The owner was asking for two times annual sales, or about $1.2 mil ion. Since other document destruction companies had been sel ing for three times annual sales, Bob and Trace thought we ought to buy it. In fact, they were making the most common mistake in the book.
You can’t value any company simply by looking at its sales. Yes, it’s true that every industry has a rough rule of thumb for doing valuations, and usual y it’s expressed as a multiple of sales, but that’s simply a matter of habit and convenience. What most buyers are interested in is something cal ed free cash flow, and free cash flow is a function of profit, not sales.
As it turned out, the company Bob and Trace were talking about had very little profit at al . It consisted of a father and his son who had a truck with a shredder on it. Al they cared about was earning a living, which they could accomplish by doing massive amounts of shredding at an extremely low price—6¢ per pound. They probably did al right for themselves, but the business had absolutely no value to a company like ours.
To begin with, it would cost us more than 6 ¢ a pound just to col ect the paper and make sure the shredding was done in a secure manner—
forget about any contribution to overhead. Of course, the father and son could forget about overhead: they didn’t have any. They had no significant expenses above and beyond the cost of actual y providing the service. As a result, they could get by without producing gross profit. But no business that does have overhead can survive without gross profit. It’s the gross profit that covers the overhead expenses and provides the net profit you need to build the company and get a return on your investment. We would never consider buying a business without gross profit. We wouldn’t even buy the father and son’s customer list. Once we started charging realistic prices, the chances of our holding on to the customers would have been zero to none.
So how, you might ask, did the father and son ever get the notion that their business was worth $1.2 mil ion? The same way most people do.
When you hear that a company in your industry has sold for three times sales (or whatever), you natural y figure that your company must be worth something in that range, just as you’re likely to think your house is worth approximately what the one down the street just sold for—even though you know nothing about what’s in that house or why the buyer wanted it.
I final y cured myself of that tendency by talking to people interested in buying my company, and I’d recommend that other business owners do the same. You need to begin by understanding what potential buyers are looking for. That, of course, depends a lot on who the potential buyers are.
Some companies do acquisitions for strategic reasons, some because they want to gain market share, some because they see a potential for synergy, and some because they want to boost their bottom line. Whatever may be driving them to do a deal, however, it’s a safe bet that they wil look first at your earnings before interest, taxes, depreciation, and amortization, or EBITDA. When you subtract from that number the minimum amount of new capital expenditures required each year (or CAPEX), you get a pretty good measure of free cash flow. That is, you see the amount of cash a company generates in a year after paying al of its operating costs and expenses and meeting its minimum new-capital requirements but before covering what it owes in taxes and interest (which the acquirer might not have to pay) and before deducting depreciation and amortization (which are accounting mechanisms reflecting the cost and life span of certain assets).
Assuming acquirers can determine your company’s EBITDA, other factors then come i
nto play. I say “assuming” because most smal companies don’t have audited financials and don’t keep financial records good enough to let them even make a reasonable guess at EBITDA. Without that information, you probably won’t be able to sel your business to a sophisticated acquirer, and you certainly won’t get top dol ar for it.
Let’s suppose, however, that your company has nice, solid EBITDA and you can prove it. You’re stil not home-free. Acquirers wil want to know where that EBITDA comes from. Do you have a broad, diverse base of customers? Have they signed long-term contracts with you? Are your prices in line with the market?
I know a guy in an industry where some companies are going for three or four times sales. He’d like to sel his business and can’t understand why no one wants to buy it. The trouble is, he has a couple of big customers that contribute more than half of his sales, and they’re paying through the nose. That can happen. Maybe an account has grown over time, and the customer isn’t getting the discounts it’s entitled to. Maybe the person it has overseeing the account is incompetent, or not doing the job properly. Whatever the reason, you make out like a bandit in the short run, but in the long run you have problems. As soon as the customer wakes up, you’l lose the business. If the account represents a large percentage of your sales, the loss could be devastating. Smart acquirers wil take note of the danger and discount your business accordingly—or maybe decide it’s not worth buying.
But let’s assume you have a wel -run company. What you can get for it wil probably be somewhere between five and ten times EBITDA. (I’m excluding Internet-based “concept” companies here, or at least those with the potential for explosive growth, which get valued according to a set of rules al their own.) The exact multiple depends on various factors, such as interest rates. As they go up—and money becomes more expensive—
the multiple tends to fal . If they go down, the multiple usual y rises. It can also be affected by the amount of competition among potential acquirers and the number of good businesses available, as wel as other factors related to your particular company. Unused capacity, for example, might boost the price. But in the end it wil be somewhere between five and ten times EBITDA no matter what industry you’re in.
Why? Because what acquirers buy is the potential to make money in the future. The more money they’re likely to make, the more money they’re wil ing to pay. Conversely, the greater the risk that the cash flow wil be cut off prematurely, the less they’re wil ing to pay. Yet, as obvious as that may seem, it’s not how people in your industry wil talk about what an acquirer has paid for your company after you sel it. In fact, it’s probably not how you’l talk about the price you got. Instead, you’l convert it into a multiple of sales or some other rule of thumb that everybody is familiar with. In the records storage industry, for example, we often hear that someone has sold a business for so many dol ars per box. That may literal y be true if the acquirer has bought only the accounts and the boxes that go with them, but if the whole business has been sold, the rule of thumb is just a form of shorthand. Regrettably, it gives people like the father and son shredding team the wrong idea about their company’s value.
So did al this mean the father and son would never be able to sel their business? Not necessarily. I doubt any rational human being would ever have paid $1.2 mil ion for it, but it could have had value to the right type of buyer, namely, a person much like themselves. The first question was, did the business generate enough cash for someone else to earn a living from it and stil have money left over to make monthly payments to the father and son for, say, five or six years? The second question was, would that be a better deal for the buyer than simply starting from scratch? I can’t answer those questions, but I hope that the father and son did before they made plans to retire on the money they would get from the sale of their business.
The Bottom Line
Point One: Whenever you launch a new business, keep track of your monthly sales and gross margins by hand until you have a good feel for them.
Point Two: Find the key number that tel s you how your business is doing in real time, before you get the sales report.
Point Three: More sales usual y mean less cash flow. Figure out your future cash needs while you stil have time to address them.
Point Four: Understand EBITDA, and use a multiple of that—not sales—as the measure of your business’s value.
CHAPTER SIX
The Art of the Deal
Before we go any further, I want to take some time to talk about negotiating, which is—as I’m sure you realize—a fundamental business skil .
Indeed, much of business is negotiating. From the day you start thinking about having your own company to the day you cash out, you’re involved in one negotiation after another. You may cal it something else—“raising money,” “sel ing,” “leasing space,” “hiring,” “buying insurance,” “getting a phone system,” whatever—but you’re negotiating every step of the way, and you’l pay a price if you don’t recognize the process for what it is. Why?
Because you’l be inflexible. You’l focus too much on your own needs, and you won’t hear what the other party is saying. As a result, you’l miss opportunities to get better deals.
I can give you a fairly typical example that arose at one point when we had some unexpected delays in the construction of one of our warehouses.
It became clear that the warehouse wouldn’t be finished in time to accommodate al the new boxes we’d be getting in. We’d have to find additional storage space immediately, and not just any space. We needed a particular type of warehouse, one with very high ceilings; it had to be located within a few blocks of my facility; and we had to be able to move in at once.
I knew there were only a handful of places that could meet the first two conditions. As a result, I would be in a pretty tough negotiating position.
Anyone who could meet al three would have me over a barrel. Had I been thinking only about finding the space, I might have been tempted to throw myself on the mercy of a real estate broker. But I was also interested in getting as good a deal as possible, which ruled out that approach. If I wanted to get the space and a good deal, I’d need to negotiate.
The negotiation began with my cal to the broker. That’s a general rule: you start negotiating when you have your first interaction with an outside party. I told the broker my specifications and said I was wil ing to pay the going rate—about $5.00 per square foot. He said there were very few such places available in my area at any price.
I said, “Wel , I’m also looking in other areas. See what you can come up with. I’d like to stay around here, but—if the price and terms are ridiculous—I’l go somewhere else.”
This was at least partial y a bluff. Going somewhere else was the last thing I wanted to do. Yes, I would have considered it if the price and terms were absolutely outrageous, and I was keeping an eye out for good deals in other parts of the city just in case. But I didn’t want the real estate agent to know exactly how important it was for me to find space in the area. In a negotiating situation, you have to keep the other party guessing about your real needs and priorities, or you may not get what you want. If you do get it, you’l have to settle for a less attractive deal.
The broker cal ed back a few days later. He said he’d found a place that met my requirements. Why didn’t I take a look? I did. It was perfect. “This might be OK,” I said to the broker. “What’s the price?”
“The owner wants $6.50 per square foot and a five-year lease.”
“Ridiculous,” I said. “I won’t pay over $4.75.”
Again, I was bluffing. I’d have paid his price if I had to. My need was that urgent. But now I had another factor to consider. Our second warehouse was going to be ready within a few months. If I signed a five-year lease, I ran the risk of being stuck with too much capacity. So why did I focus on the money rather than the terms? It was a matter of strategy. That’s another one of my rules: negotiate first about a secondary matter,
understanding that—at the end of the process—you’l probably let the other party get most of what it wants on the issue in question. Your concession on the first negotiating point wil give you additional bargaining power when you bring your number one issue to the table.
For the next few weeks, we haggled over price, with the broker serving as the go-between. Eventual y, the landlord came down to $5.80 per square foot, and the broker told me he wouldn’t go lower, since he already had two other tenants paying that rate. I said, “Wel , there are other issues involved here. Maybe he and I ought to sit down and talk.”
A face-to-face meeting of the principals is always a crucial point in a negotiating process, and most people blow it by concentrating al of their attention on getting what they want. Negotiating is give-and-take. To get what you want, you first have to find out what the other party wants. There’s only one way to do that—by listening. I make sure I listen by fol owing two more of my negotiating rules. The first is: don’t go in with any preconceived notions. By that, I mean don’t make any assumptions about what the other party is thinking. Right or wrong, your assumptions wil cloud your mind and keep you from hearing what’s being said.
The second rule is: always assume that everyone else in the room is smarter than you. If you get the idea you can outsmart other people, you stop paying attention to them. So I bring a yel ow pad with me to negotiating sessions. On the fourth or fifth page, I write the word dummy three times.
