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Joan M. Ridley
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Company Profitability Does Not Always
Add Up to Company Value

by

Joan M. Ridley, CFP

If your company has been profitable for the last few years or more it would be natural for you to assume that it has a certain level of value. But, profitability is only one benchmark of value for most potential acquirers. While profitability is often the door opener, it is a well-executed plan for sustained long term growth and cash flow that will hold a prospective buyer’s attention and set the stage for an impressive offer.

One Company’s Story

Tom Smith owned a small manufacturing company that he started 10 years ago. It had grown to 60 employees with $15M in gross revenues, and took $3 M to the bottom line. Tom was 57 and had always planned to exit the business when he reached age 63. That was the extent of his exit plan except to occasionally play with the idea that some large company would want to acquire his some day.

That day arrived very unexpectedly when Tom received a call from the acquisitions specialist of a publicly traded company (call him Harry), even though Tom was not planning to sell for another six years. Tom was well aware of Harry’s company and often thought if ever he would be acquired by a large company, that one would be his choice. It was a growing enterprise and well-respected in his industry. Not to be overlooked were its deep pockets and capability to pay top dollar. He had only dreamed of selling to a company like that. It had a few features that made it very unique and highly desirable as a potential buyer. So, when Harry called Tom out of the blue just to get together over lunch, Tom, who was otherwise too busy, readily agreed.

“We’re in an acquisition mode”, Harry told Tom. Over a “casual” lunch, Harry proceeded to share with Tom his company’s expansion plans. “Your company is unique and has the product line we are looking for. We are especially interested because of your vast knowledge about the industry and your reputation. That makes you unique, Tom”. The gentlemen chatted and Tom shared something about his business model and customers, even though he didn’t mention them by name. “I am impressed with your business model and would want you to remain in control of your company after the acquisition, acting as a consultant to help us set up other operations like yours.” That sounded good to Tom since he didn’t want to leave the business for several years anyway. “If you are at all interested, I’ll get you our Non-Disclosure Agreement (NDA) to sign which will totally protect your confidentiality. The next step would be to get us your financials.” Tom thought it wouldn’t hurt just to find out what this company would offer him.

Tom came away from the meeting feeling like Harry was someone he could work with. They had a similar background and had an instant rapport. Tom was also pleased because he felt that he had come away with a lot of information about Harry’s company without giving up too much information about his own. It never occurred to Tom that the information that Harry had shared was readily available since his was publicly traded. The NDA was signed by all parties and Tom sent off his financials to Harry. He did not have his attorney review the NDA thinking that he would not engage him until it seemed necessary.

Harry’s company was very interested and after a few more meetings Tom quoted Harry the price and terms that he would accept. He figured the company was worth at least his industry standard multiple of cash flow so a valuation was not necessary. The parties signed a letter of intent that met Tom’s asking price and terms. Harry’s company sent in his due diligence team to examine every aspect of Tom’s company. Harry’s company subsequently withdrew its offer and thanked Tom for his time. The company said there were several reasons for its withdrawal but did not reveal what they were except that the company was re-thinking its business model.

Lessons Tom Learned From This Experience

He was not prepared. He did not have a written strategic plan or any systems in place to insure sustained long term growth and future cash flow. If he had done that, any deterrents to completing a transaction for top dollar would have been identified and corrected long before Harry arrived on the scene.

He should have had his attorney review the potential purchaser’s NDA for any necessary changes appropriate for this type of potential transaction before signing it, or he should have insisted that all parties sign the document drafted by his own attorney.

He allowed Harry to engage him. He would have been wise to turn the entire process over to an experienced transaction professional to represent him as soon as he received that first phone call from Harry.

If he had done that:

  • His representative would have pre-qualified the prospective purchaser to determine if Tom’s company fit the profile of a likely acquisition before revealing information about his company.
  • His representative would have known what Harry’s company was looking for and would have known what to emphasize about Tom’s company and what to downplay.
  • His representative would have advised him about the price and terms he could expect, and might have recommended that Tom retain a qualified,credentialed valuations professional to help determine a realistic value.
  • His representative probably would not have quoted a price and terms to the prospective purchaser, but would have allowed the potential purchaser to assign a value based on its own strategic business plan.
  • Tom would not have taken his focus off his business and wasted his valuable time.
  • Tom and the prospective purchaser would have signed an NDA prepared by Tom’s attorney, or Tom would have signed the prospective purchaser’s NDA only after his attorney had looked it over and made any necessary changes.
  • Harry and his acquisitions team would have been alerted that Tom was savvy enough to retain professional help to represent his interest and that he was not someone who could be easily flattered or taken advantage of.
  • It would have sent a signal to Harry that Tom was accustomed to receiving unsolicited offers and that Harry’s company should expect competition.

Value is in the Eye of the Beholder

Tom’s story is a common scenario. The bottom line is that a seller’s criteria for value are dependent on how he views his company. If he views it as a source of revenue and sustenance of his and his family’s lifestyle, then he will tend to assign value based solely on profitability and cash flow. If he views it as an asset, he will tend to assign value based on how well the company has executed a welldocumented, written strategic plan and how it is positioned for future growth and increasing market share. Viewing your company as an asset rather than a source of income is a critical step in growing the company and increasing the net worth of the shareholder(s).

 

Joan M. Ridley is president of Business Wealth Solutions, a Dallas-based advisory firm that consults with business owners about how to successfully grow and leave their business. Visit our website at www.bwsllc.net. Call us today at 214.692.9192 for a complimentary meeting to learn how we can help you get where you want to go.

Copyright 2006 Joan M. Ridley

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