Thursday, August 30, 2012

Key Value Drivers - The Hierarchy of Recurring Revenue

The customer base is a key value driver for most businesses.  In addition to a diversified client base and the potential for future revenue growth, purchasers are very interested in companies that have strong customer relationships that lead to repeat business.
The extent to which future sales can be predicted with some degree of confidence is a major factor in determining the value of a company.  Projections are inherently uncertain and a recurring revenue stream provides greater confidence in the ability to predict future revenues.  Creating a recurring revenue stream is one of the best ways to increase the value of a business and command a higher price in the marketplace.
There are various forms of recurring revenue.  The list below outlines six forms of recurring revenue presented from least to most valuable in the eyes of an acquirer:
6.  Consumables:  disposable items that customers purchase regularly that can be, but are not necessarily, "brand-loyal" such as shampoo, bottled water or batteries.
5.  Sunk money consumables:  disposable items that require an initial investment in a "platform piece" such as razor blades or electric toothbrushes.
4.  Renewable subscriptions:  items that are paid for in advance for a period of time such as magazine subscriptions or monthly passes for public transportation.
3.  Sunk money renewable subscriptions:  products or services that require an initial investment and an ongoing user fee such as a Bloomberg Terminal and corresponding subscription fee for access to the financial information.
2.  Automatic renewal subscriptions:  products or services for which a fee is automatically charged monthly until the client specifically opts out such as document storage or satellite radio subscriptions.
1.  Customer contracts:  products or services that require a hard contract for a pre-defined term such as wireless phone contracts or commercial cleaning services.

The largest transfer of private wealth in history will occur over the coming decade.  The increasing supply of businesses for sale over this time period will create a buyer’s market, in which buyers will only pay top dollar for the most attractive businesses. 
Business owners looking to sell (for a premium) over the coming decade must assess the quality of their existing revenue streams and, where possible, implement measures that will help move them up the hierarchy of recurring revenues.
If you are building a business to sell one day and are curious to see how the quality of your revenue stacks up, take the 13 minute Sellability Score questionnaire:

Friday, August 24, 2012

Exit Planning - The Difference Between Value and Price

Some would argue that a business valuation is not useful to business owners for exit planning purposes because the valuation can become outdated quickly and it may not provide an accurate assessment of what a potential purchaser would be willing to pay for the company.
Although I generally agree with this reasoning, I believe that a valuation can be very useful to business owners in exit planning.
Fair market value (FMV) is a common value term used by business valuators.  According to the International Glossary of Business Valuation Terms, FMV is defined as follows:

"The highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts."

FMV is a notional market concept.  Price, however, is what is agreed upon by parties in an actual transaction.  Under certain circumstances FMV and price will be similar, however, the two will rarely be equal.  This is because certain factors reflected in price are generally not reflected in FMV, including:
  1. Economies of scale or synergies:  Potential cost savings, increased sales, eliminated competition, etc., that may result from combining the target company with the purchaser’s existing business, are generally not reflected in FMV
  3. Negotiating strength:  Relative bargaining abilities of the buyer/seller and their individual perception as to the future of the business and risk will affect price but not FMV
  5. Transaction structure:  Price will often include non-cash consideration whereas FMV is expressed in terms of cash
  7. Underlying motivations:  Buyer/seller motivations for purchase/sale that impact price are generally not reflected in FMV
It is true that an outdated valuation may not be useful to business owners when the facts and circumstances affecting value have changed since the valuation date.  However, a current FMV assessment can be useful for exit planning purposes for the following reasons:
  1. FMV can be used in negotiations with a potential purchaser because buyers generally consider the same valuation approaches and techniques used by business valuators in a FMV assessment
  3. FMV provides a good intrinsic value benchmark (i.e. prior to economies of scale or synergies) that is useful for identifying and implementing value enhancement initiatives
  5. FMV can serve as a basis for a pricing analysis, which does consider value from the perspective of a specific purchaser and attempts to quantify the economies of scale or synergies that may be realized by incorporating the target business with the purchaser’s existing business
At the end of the day price will be determined through negotiations between a buyer and seller which will be influenced by negotiating strength and a supportable value analysis.  A current valuation or pricing analysis prepared by an independent business valuator may provide the business owner with the edge needed in negotiations with a potential purchaser.

Monday, August 20, 2012

Exit Planning - Consequences of Not Planning Can Be Severe

According to a 2008 White Horse Advisors' survey of closely-held business owners, 96% percent of Baby Boomer business owners agreed that having an exit strategy was important, but 87% did not have a written exit plan. [1] 

The consequences of not having an exit plan can include, among other things, lost opportunity, wasted time, effort & money as well as decreased business value.  These consequences were illustrated in a recent client matter involving the unplanned exit of a majority shareholder.

The Scenario:

A manufacturing business owned 80% by the majority shareholder, 12% by unrelated individuals and 8% by management. 

The majority shareholder was forced into an unplanned exit when he suddenly passed away.  Basic tax and estate planning was in place but no formal exit plan existed. 

The estate now owned an 80% equity interest in a privately held manufacturing business. The beneficiaries were not active in the business and wanted immediate liquidity.

The Transition:

Management expressed interest in acquiring the estate’s 80% shareholding.  Expecting a smooth and timely process, the beneficiaries decided to pursue a management buy-out (MBO) as opposed to a third party sale on the open market. 

We were retained by the beneficiaries to provide an independent fair market value assessment as support for the price to accept in the MBO.  Although the parties agreed on price, they could not agree on the transaction structure.  After one year of negotiations the deal had not closed and the parties agreed that, due to external factors, the value of the business had declined over this period. 

We were again retained to value the business for purposes of the MBO.  The market value had in fact decreased by approximately 5% to 10%.  Transaction structure was still a major issue as management had difficulties financing the transaction.  Ultimately it took two years to finalize the deal.

The Consequences:

The majority shareholder was not prepared for this involuntary exit.  The beneficiaries of the estate assumed that a MBO would be a quicker and smoother process than pursuing an external sale on the open market. 

Unfortunately this process took two years and the value of the business decreased over the course of extended negotiations.  Significant transaction costs (accounting, legal and other expert fees) were also incurred by the parties over the two year process.  In addition, an external sale to a strategic or financial buyer may have fetched more than that agreed to between the beneficiaries and management.   


87% of business owners surveyed by White Horse Advisors in 2008 do not have a written exit plan, many of which do not appreciate the potential severe consequences awaiting them - neither did the majority shareholder in the above noted client situation!

[1]   Source:

Saturday, August 11, 2012

Exit Planning – Ingredients For An Effective Strategic Planning Session

Step 6 of the exit planning process (Action Plan) begins with assembling the key individuals for a strategic planning session.  These individuals could include the business owner(s), the family, management and professional advisor(s).
The objective of the initial strategic planning session is to identify at least 10 different strategies that will help accomplish the exit planning goals.  Subsequent meetings will be devoted to prioritizing and selecting the specific strategies to implement and to assign responsibilities.

How do you ensure meeting objectives will be achieved when, according to a Microsoft office survey of 38,000 people, 69% of people feel that meetings are not productive?
An effective meeting begins with sufficient planning and ends with proper follow-up.  A meeting Chair is also required to ensure the proper planning, execution and follow-up steps are implemented.
1.  Planning

Proper planning involves setting and distributing an agenda to all meeting participants in advance of the meeting.  The agenda provides an overview of the meeting objectives and topics that will be discussed at the meeting.  Timing for the meeting will also be highlighted, including the start time, end time and time allocation for each topic.

Key agenda items for an initial strategic exit planning session include:

  • Restating the exit planning goals;
  • Brainstorming obstacles that will prevent the achievement of these goals; and
  • Brainstorming strategies that will overcome the obstacles and help meet the goals.

2.  Execution

Two important considerations for running an effective meeting include establishing meeting rules and ensuring active participation.

Meeting rules provide the structure and process for active participation.  Examples of meeting rules include: "one person will speak at a time", "all have a chance to be heard" and "only items on the agenda will be discussed".

In order to keep people engaged and ultimately reach a consensus on any decision, active participation by all attendees is required.  It is the meeting Chair’s role to encourage quiet individuals to share their thoughts and to ensure no one person monopolizes the discussion.

At the end of the meeting, the Chair should ask attendees for feedback on whether or not they felt that the meeting objectives were achieved.  This will help improve the effectiveness of future meetings.

3.  Follow-up

Following-up after the meeting is key to ensuring an effective strategic planning session.  This will remind attendees what was accomplished during the meeting and what action items are required before the next meeting.

Meeting minutes should be distributed to all attendees within 3 to 4 days.  The minutes will identify accomplishments made and detail the action items, responsibilities and due dates agreed upon during the meeting.

The meeting Chair will then follow-up with everyone to ensure they understand, and are working on, their assigned action items.  Agenda items for the next meeting should also be canvassed.


It is unfortunate that more than two thirds of people surveyed feel that meetings are not productive.  Effective meetings take effort and a skilled meeting Chair is required to ensure all the ingredients of an effective strategic planning session are present.

Friday, August 03, 2012

Not All Valuation Reports Are Created Equal

The quality of a business valuation report depends upon the reasonableness of the underlying assumptions made by the valuator.  The valuator’s judgment (or lack thereof) in assessing and supporting the reasonableness of the underlying assumptions can have a significant impact on the reasonableness of the overall valuation conclusions. 

Differences in judgment among valuators will often result in different value conclusions for the same business entity as at the same valuation date.  In addition, various errors and omissions in a valuation report can lead to an erroneous value conclusion.  It is important for those relying on a business valuation report (e.g. business owners, management, accountants, lawyers and other professional advisors) to be aware of some of the more common errors and omissions made by valuators. 

According to "A Reviewer's Handbook to Business Valuation: Practical Guidance to the Use and Abuse of a Business Appraisal" [1], the 12 most common errors and omissions found in tax court appraisals include:

  1. Failure to comply with applicable professional standards (e.g. the CICBV in Canada);
  2. Overstatement of valuation credentials (or inadequate listing of credentials);
  3. Too much involvement by the attorney;
  4. Misapplication of the standard of value;
  5. Misapplication of the valuation date (most commonly, the inclusion of hindsight);
  6. Failure to identify the correct business interest to value;
  7. Bias and/or lack of independence;
  8. Incomplete or incorrect sources of data;
  9. Pure reliance on case law;
  10. Failure to make a site visit or conduct management interviews;
  11. Failure to create a replicable analysis; and
  12. Inadequate explanation or support for the valuation analysis and conclusions.

Ironically, business appraisals can also suffer from too much information and analysis. According to Hood and Lee:

"The court’s first objection to appraisals is an overarching concern that there are diminishing returns in extensive numerical analyses in the appraisal process and that, no matter how the appraisal is fashioned, it has many areas for subjective determination along the way, which culminates in a subjective opinion."
Although the above noted errors and omissions are based on a review of tax court rulings in the United States, they are very likely equally applicable to valuation reports prepared in Canada.

When you retain a CBV, you will likely have an opportunity to review the report in draft form before it is finalized.  Make sure to consider these potential errors and omissions when reviewing the draft report and question the valuator where you suspect an error has been made before the report is finalized.

[1]    Published by Wiley, authored by L. Paul Hood Jr. and Timothy R. Lee