Running Your Business Before the Sale
In the state of nature profit is the measure of right. -Thomas Hobbes, 1679

Indeed, profit is the key to many things, none more so than in measuring the value of your business in a transaction. To that end, the key to running a business prior to a transaction is to manage for profit. After all, your investor is going to be taking stock of that profit when it comes time for valuation.

Below we'll take a look at a few key items that can influence your profitability and discuss how you should consider handling them.


Capital Expenditures

Is it time to replace that aging boiler? Or would that new 5-axis mill make you much more productive? Is that good financing plan proving too tempting? Before you take the plunge, consider what happens when you do.

Let's assume that your company has been generating earnings of $2.5m EBITDA fairly steadily over the past three years. You are considering a sale next year, and at the same time eyeballing an investment in a new machine tool that will cost $900k. The machine will increase overall productivity in the factory by 7%, and it will have a useful life of 7 years (and be depreciated straight line as such).

What is the impact to a potential buyer? Simple: you have reduced your earnings by some $750k+ (or perhaps added that as debt to your balance sheet). Either way, you have a drag on earnings. The buyer is going to look at your earnings, and for the sake of simplicity using a simple multiple of 4x EBITDA, look at a valuation in the range of $6.9m (4.0 x EBITDA of $1.7m).

What if you hadn't made that investment? The valuation would have been $10m (4.0 x $2.5m EBITDA). That is a 30% difference in price!

Caveats: A simple multiple of EBITDA is a very common rule of thumb for valuing a small business. That said, smart investors realize that some ongoing level of capex is required. In such cases they will seek to normalize or annualize ongoing capex requirements, subtracting that from EBITDA to derive a valuation. In the above example, a buyer might determine that, on an annual basis, $250k is required for capex improvements or replacements. The valuation would then be $9m [4.0 x ($2.5m EBITDA - $250k annualized capex)].

Take-aways: Delay or defer unneeded Capital Expenditures prior to a sale, and be prepared to discuss your rationale for your on-going capex program.


"Cash in the Business"

We see this time and again: business owners seek to either obfuscate their earnings to minimize their tax bill (think running your personal expenses through the business, such as excess travel costs, car payments, etc), or they don't report "cash" revenues entirely.

Without getting into the legalities of any of the above, let's look at the effects of one of the above scenarios.

Let's assume that you have the same company, earning $2.5m EBITDA, and you have $250k in "cash" that you have not reported as revenues for the company. (This could just as easily be $250k in "personal expenses" that you run through the company). Assuming a simple multiple of EBITDA, you would like to see an offer for $11.0m [4.0 x ($2.5m EBITDA + $250 "cash")].

A more likely scenario, though, is an offer of $10m - completely discounting the un-reported earnings. Most buyers will not accept on faith that the money exists. As the old maxim goes, you cannot have it both ways. You must either report your financials accurately, or not expect to get paid on the unreported earnings.

A Side Note: We always hear the argument that the business owner just "doesn't want to pay tax" on those earnings. But what are you really saving? Consider this: using the above example, had you reported an additional $250k in earnings, you would have had another $100k in taxes you paid, thus pocketing only $150k of additional post-tax profit. But what is that $250k worth in a valuation? Using the above: $1.0 million. Does it really make sense to avoid that $100k of taxes and forego an extra $750k in the valuation? Clearly, not.

Take-aways: When you are getting ready for a sale, run your business like a public company. Report your expenses accurately, keep your personal expenses personal, and absolutely report all of your revenue.


Run it Like You'll Keep It

We tell our clients time and again: "never take your foot off the gas." A buyer never, ever wants to see revenues dip once you have begun the sale process. You are effectively telegraphing to the client that something is wrong with the business. Their immediate thought is that you know something that they don't and are seeking to cut your losses and run.

Finally, always hedge your bets. Given that there is no surety to a transaction closing until the ink is dry, make sure you keep running your company like you'll be keeping it. At the end of the day, should a transaction not close, you'll want a business that remains strong and robust.