In this episode, we're coving the year before considering M&A: how to prepare your business for the next chapter and things you should be thinking about now before diving into the murky waters of an exit or acquisition. From revenue, to profit, to business expenses, to forecast - we're covering what you should be thinking about now.
Considering a sale? Listen to a few other recent episodes where the team discusses Seller Readiness:
SUMMARY KEYWORDS
business, buyer, revenue, firm, sales, selling, thinking, cash, mike, offerings, balance sheet, forecast, companies, capital, year, big, ryan, aligning, working, debt
SPEAKERS
Mike Harvath, Matt Lockhart, Ryan Barnett
Mike Harvath 00:04
Hello and welcome to this week's Revenue Rocket Shoot the Moon podcast, broadcasting live and direct from revenue rocket world headquarters in Bloomington, Minnesota. Today, I'm happy to have my partners Ryan Barnett and Matt Lockhart on. And we are going to talk about how to prepare your business and things to do in your business, If you're thinking about an exit, at least one year in advance. So with that, I'll turn it over to Ryan.
Ryan Barnett 00:34
Hey, good morning, Mike. And hey, Matt.
Matt Lockhart 00:37
Hey, guys, fun topic today. I think this is a good one.
Ryan Barnett 00:41
Yeah, I think so too. Is it weird, we're looking at a little bit to come some of our own offerings. So if revenue rocket we provide m&a is really our focus. But we spent a lot of time and we have a long heritage within growth strategy for firms. When we take a firm to market, what we typically do is, we take a look at readiness and as a firm really ready to sell. And today, we'd like to take a wind the clock back a little bit and ask questions about if you're to take your firm a year from now and take it to market, what things can you do in that year before you consider a sale process? And what kind of things can you do to help maximize your value to help transition to help move things forward? So today, we'd love to kind of take that year, one year before sales side, a process begins and what you can do and Matt, love for you to just start out and what do you think, Where can someone start in this discussion?
Matt Lockhart 01:45
Sure, you know, let's let's harken back to some of the things that we've talked about before. And, and, you know, the, in the very biggest blocks of getting ready to sell your business first. There is an emotional, you know, step that needs to be taken. And you don't have to take that final step until you consummate a deal. But emotionally, you're starting to prepare yourself for the idea of having a new chapter of, you know, transitioning your business have, and has some extent letting go. Right. And so, you know, I just wanted to start there. And it's not an easy thing, especially in a founder led business, for somebody to think about themselves in, in a different chapter in a new chair and the light. Right. So, you know, that's, that's kind of a softy thing, if you will. But then moving into, you know, what are some of the bigger blocks that we're going to talk about, right? Obviously, there is the the overall financial picture of the firm. And there's a lot to unpack there in terms of, of financial readiness, and it's not something that you can really flip a switch on, you need to start to prepare for. And then in the context of marketability of your firm is thinking about what in the marketplace, what capabilities, what offerings, what intellectual property is, is going to bring the highest level of value, and how can you make sure that you're aligning along those lines? So that's another big block that I think we can unpack that. And then, you know, thinking ahead around succession, and people, I think is another big a big area that there's a lot to talk about there Ryan.
Ryan Barnett 03:56
Thanks for setting that up. Your emotional journey is absolutely right. Mike, you've often talked about this. And in a lot of our process, we end up becoming a bit of a therapist in understanding where things are gonna go. Mike, can you drill into that a little bit on kind of getting ready emotionally to sell what's that mean for a CEO and people who are going through the process?
Mike Harvath 04:22
Yeah, I always think it has to do with putting some thoughtful time into what's next for you. Right. You know, we've certainly talked some about that in our previous podcasts about selling in or selling out, but you have to have absolute clarity about what your journey is going to entail, post close, and have alignment around that and be able to articulate that where I see you know, founders of businesses have the biggest challenge personally, post close, Is when they haven't put that time in early on and probably out a year or years. As to kind of what their plan is their life plan post close, obviously, it takes a lot of energy to start and grow any business, but particularly a tech services business. And you have to be prepared for, firstly, what's next for you? Now, there is no real right and wrong answer here. We've had a lot of people ask us, Well, you know, what does a buyer want to hear for an optimal answer and blah, blah, blah, I don't know that there is one. But clarity is critically important. Because it'll help you and help your advisor in an m&a process, find the right buyer. And it will also help you you know, have a path to kind of happiness post close. Because it certainly would, would suck to get to the closing table, close your deal. And then wonder, Oh, geez, you know, what should I do? Now, you know, I mean, if it's too late at that point, to try to figure out, you know, what the future holds for you, and you should be well aligned on that. And we've had just to share some history, we've had clients that have started all kinds of different businesses that they were passionate about are pursuing some that were aligned with their own interests, like restaurants and, you know, Taekwondo studios and, and Marina, marinas and golf courses, I mean, the list goes on and on. For things that were they wanted to sort of shift gears in their life to work, some retired, some sold in and continued on with a new buyer, but for your journey, you have to understand and think about what's best for you.
Ryan Barnett 06:42
Yeah, I'd really encourage our listeners to check out our selling in versus selling out podcast, you have a great opportunity to, in many cases to be part of something bigger. And that's something where if you're a year out from selling something, it could be getting your firm ready to be part of a another journey and be something bigger, I will say, in those cases, in which you're, you're getting ready to be as part of something bigger, you don't necessarily have to have the highest profit margins. If you're willing to bet something on a forecast and bet something on the future, you may be selling in and being emotionally ready to grow with someone else, I think it'd be very powerful.
Matt Lockhart 07:27
You know, Ryan, I'll jump in real quick, because, you know, Mike ans sort of talked about his experience in being a bit of a counselor, and, and and then you know, your reference towards that other podcast, I think, which is great advice. And, you know, if if you hadn't already, think about who your advisors are, you know, a year beforehand, and really start to engage with them, you know, that, that external advice from people who've been there, and done it before, can, you know, open some eyes, and, and really help build that, you know, plan, and so I think we'd be remiss, and, and yeah, you can say, oh, geez, that's a little self serving as you guys are m&a advisors. And you build strategies to do this? Well, sure we do. And we'll be we'd love to talk to you about working with you. But if it's not us, you know, legal counsel, friends in your network, who have sold before, start to think about who your crew is, who your team is, that's going to help you, you know, work through the process.
Ryan Barnett 08:46
And that can certainly include Wealth Advisors, it can include tax consultants, there, those plans can start very early when it comes to this. So yeah, so if you're ready to embark on the journey, Matt, you'd mentioned something about offerings and categories. And I'd love to get your perspective on, on what you've seen and aligning yourself to the right categories. I love the example that you gave me, but I'll let you share it.
Matt Lockhart 09:15
Yeah, sure. You know, the, the market and and our technology marketplace shifts pretty darn quickly. And we're only seeing that pace of change, you know, increase and so aligning your firm's capability to what is going to be most resonant in the marketplace is something that is critical. Now, as a great business person, you've been doing that over the course of of your farms history, but you know, thinking really critically not about, you know, what you like to do, or what you do you know, today, or maybe even what you best do, but thinking about aligning your capability towards what the market is going to find the most valuable, I think is is pretty key. The example that Ryan and I were talking about was, oh, shoot, you know, five years ago, maybe, or six, IoT was at the front page of the hottest capability in the marketplace. And and, you know, for good reason, you know, people were looking at machine learning and automation opportunities and, how do you make that happen within an organization's devices? And then etcetera, etcetera, right? Well, it became pretty clear that what was underneath all of that was the concept of artificial intelligence, right, and artificial intelligence and, and realizing the gains of, of an organization's data, right, to enable automation, to enable a better customer experience, all of a sudden became the real winner. And, and so those firms that had great IoT capabilities, or at least some IoT capabilities, if they would, if they think about pivoting towards how that would apply, in an artificial intelligence sense, we're gonna get a higher valuation than a firm that was just thinking about IoT. So that's just one example. But there's, you know, there's really tons right, of examples that could be thought of, you know, for the MSPs, out there that if haven't incorporated, and bundled the appropriate cyber security components within their managed services offerings. Well, you know, what, in a year's timeframe, that's doable. Right. And, and the value of demonstrating the understanding of security, in the context of a managed service provider, is something that's going to make one more valuable. So just a couple of examples where you're offering, and what the marketplace is, is looking for, and most highly valuing is something that, you know, really can be impacted. In that, you know, in that year of preparation.
Ryan Barnett 12:48
Yeah, I think that's really well said. And I think, to add on that some areas, you can also look at our, where you might get multiple optics, if you look at even multiple, the focus on a vertical market could help a suitor, it could help you, if you have some offerings that are very specific IP that's built around those offerings and allows you to have some more sustainable, protectable Revenue. If you can shift things towards recurring revenue, and specialize in in a few areas, those of those help identify sellers that are, will be a buyers primary for your business. And it gives you a better chance for competitive more competitive offers across more people. So that overall that those that those offerings and tuning those up, it's maybe not an overnight thing, but some of it is marketing, some of its positioning that can be very helpful to to get in a category that's more favorable for for the time. To switch gears a little bit, and, Mike, I'm going to send it over to your think on this one. If you think about the financial health of a company, talk about where growth levels need to be or where profit levels need to be. If one year from a sales process, where where should the company be looking at from kind of the the macro trends within the big factors going on revenue, profit EBITA, and such.
Mike Harvath 14:35
Yeah, I mean, I think if you're looking to optimize value when you're contemplating an exit, certainly the graphs need to be as I often say, up until the right meaning your growth needs to be you know, solid and moving in the right direction in an accelerating sort of environment. profitability, I would say the same, you should be getting more profitable at scale not less, So making sure that your business is in its top quartile amongst its peers as it relates to profitability and growth are certainly great things to align the business to, so that you can check the boxes for a potential buyer who may be looking for you. And you certainly open the opportunity to maximize your value. As we've said many times value for cash flow businesses like IT services companies, is based on profitability and EBITA up at a multiple of that EBITA, and a growing, thriving business that is in the top quartile of its peers will come in to premium. And I think certainly as you look at your customer and mix, you know, highly concentrated customer mixes sort of a negative and receives in the eyes of the buyer I'd say any single customer that represents 40% or more of your business would be perceived as a negative. Now with that said, you know, we know that and it's not a typical and services companies to have, you know, up to 50% of your business and less than five clients. That's not always the case. I mean, if you're an MSP or someone that focuses on a market that has a lot of subscription revenue, or recurring revenue, that may not be the case. But for a lot of IT services companies, that is the case, and that doesn't necessarily in its own right constitute a discounted value. But I would say, you know, a high customer concentration certainly is not perceived well in the eyes and minds of buyers. And so you want to make sure that, you know, your business is aligned, accordingly. I think, you know, some of these objectives are somewhat counterintuitive to, you know, how you might be thinking about running your business today, if you weren't thinking about an X, for example, you may run a lot of expenses through the business as an owner, which are legitimate, to be to be run through business. Maybe, you know, some are questionable. And I think we've certainly seen situations like that, we would recommend you talk to your tax advisor about what's considered normative and make sure that you don't have a lot of, of expenses that would be constituted as add backs to EBITA. Because firms that have a lot of add backs are very, they're scrutinized by buyers, particularly if some of those expenses that are run through the business are questionable, either from a from a ethics perspective, or maybe even from a legal perspective and I's and lines, IRS, you know, a buyer is going to look at that they're gonna say, you know, really, you ran these types of expenses through your business, it's probably not appropriate to do so. And then they're going to begin to scrutinize everything else in the business, because it gets to your character and how you manage and run the business. And so it's important to have a clean set of financials, and a very easy to understand sort of p&l and balance sheet, one that's not levered up with a lot of debt, because all that debt will have to be, you know, cleared at sale, you're going to have to deliver the business with no debt. And so it's important if you're preparing a year or two in advance, to clean up some of these things, right, maybe clean up your practices around what you run through the business, to reduce what would be considered an add back, pay off your debt, right have little to no debt or understand you know what the debt load is. So that you can be clear about the fact that any proceeds you get from the sale of the business, you know, a portion of those is going to have to go towards retiring some of that debt. It's not like a buyer is going to acquire your business with the debt and give you credit for the value your cash flows, exclusive of that debt that just may not, that's not going to happen. They may acquire your business with the debt, but they're going to take a discount of value to cover it. So it's either gonna get paid off, or it's going to need to be accounted for in the purchase price. And I think, you know, if you go all the way sort of, it's important to have a industry standard chart of accounts in your accounting, Ledger, right. If you don't count for the business and in a way that's not standard, that makes it very challenging for a buyer to evaluate the health of your business. And things as simple as you know, not to get too far down the down the rabbit hole here, but you know, things as far as detail, revenue lines, right where your revenue actually comes from are important. If you offer a variety of different types of services, so that a buyer can very transparently look for, you know, where is the real, you know, secret sauce in this business? Where's the lion's share of that revenue coming from? How do you account for cost of goods sold? Do you do that appropriately and for a standard? So, you know, certainly there's a lot of advisors that can help you with that, you know, we as revenue rocket, do this work all the time with clients and helping them sort of align their business, from a readiness perspective, to make sure that they're thinking about the whole business and its readiness and aligning it to what would we would consider industry standard, and that, you know, the trends for kind of up into the right are working and you're growing, and you're, you know, profitable, and you're kind of in the top quartile. But also that things as simple as your chart of accounts are set up properly.
Ryan Barnett 21:06
Yeah, to echo that, as a person who puts together a lot of the marketing material, the the, we get a lot of questions about the breakdown of revenue, we want to understand their revenue by customer and revenue by customer by product line and their service line. Those are all things to look at when you take a look at your your financial accounting systems, that they're, they're accurate, that they they're working, that you're there capturing expenses, capturing revenue, and you're able to report on them in a timely fashion. It is a bit of a test for some buyers to understand the financial health of a company, simply on how fast you can produce some of the materials that they're asking for. So if you're, if someone's asking for a five year p&l, that should be right on your fingertips and should be relatively easy to produce. And if it's not, then take some time to fix those accounting systems to get to a place that actually has reliable reporting. It's really critical to for the trust of the financials going forward. Mike, before I get off this topic, I want to go a little bit deeper on just one small thing. But it's, it ends up being a big thing at the end, can you talk a tiny bit, and we have another podcast on this, so we don't need to go too deep, but available cash on hand, the kind of the year before sale, that has a big impact on the working capital calculations at the end. And we oftentimes see companies hoarding a bit on their balance sheet or hoarding with the cash. And that at the end of the day that can ultimately kind of hurt is as companies are looking for, you may see buyers, calculating net working capital, based on what you've held for the last year. So Mike, is there any suggestions or you know, one year, you know, we're talking to a seller a year from now that they should start to look about today, when it comes to the cash on hand and the balance sheet and for that working capital calculation?
Mike Harvath 23:12
Yeah, I mean, cash management is always a big topic, if you're going to prepare for sale. And I think you bring up a good point, Ryan, which you really need a pro negotiating your working capital harvest as a seller, the only time you can harvest your excess working capital that you use in the business, is when you sell. And I would say that most often entrepreneurs over capitalized their business because they just don't want to get in and out of their credit facility all the time and carry the carrying costs or the interest associated with that, all that stuff. It you know, if you have the cash, why not create a better cash buffer, so that you don't have to worry about all of that, you know, coming in and out of your credit line and all that stuff. And a lot of companies do that. And frankly, a lot of companies balance sheets have gotten much healthier, in some cases through COVID because they've had, you know, some disaster relief funds that help them either retire debt or or help them you know, prop up their cash position. So you might be carrying quite, you know, quite a bit of cash on your balance sheet. The challenge with that is that, you know, a traditional view of, or at least a view that I would say many buyers take is one that you know, if you have excess cash on your balance sheet for whatever reason that you're not really using, you must have it there for some reason. And the logic is they want to do average working capital coverage ratio. I want to talk about a coverage ratio it has to do with you know, current assets minus current liabilities in the strictest sense, should be enough working capital to run the business provided you're in a normative collection cycle, right? Now, usually people and that's working capital ratio one, or a net working or net zero working capital is what it's called. So both of those things are the same. Now, most people keep a slightly more cash than that, which is fine. But we think it becomes a little bit of a hairy negotiation, or can, if you're keeping two or three or four times that amount of cash on the balance sheet. Because those buyers who are looking for a discount on the purchase price might argue that, well, why would you keep four times the amount of cash you need on the balance sheet? And last you needed it? Right. I mean, that's the argument, I think what's a smarter approach is, you know, maybe you should roll some of that executive that extra cash into an investment account, that's off your balance sheet, and certainly, you could draw upon it or use it at a different time. But then that would take that conversation of you know, the the material access working capital, off the table, you could put that cash to work probably in the markets better than you could just leaving it sit in cash on your balance sheet. So it's certainly something that you should talk to your financial advisors about. You should talk to a m&a advisor about as to the way to best position, your coverage ratio. So when you have enough capital, to take care of the dips, and valleys and peaks and valleys have your needs for working capital in a given year, but also that you're not wildly over capitalized, because that certainly can open up a negotiation, or in some cases, a contentious negotiation, about how much working capital is actually required, you will need a very knowledgeable adviser to have that conversation in order to maximize your harvest. Certainly, that's something we do with our clients all the time.
Matt Lockhart 26:59
You know, and I think it speaks to predictability to Mike I mean, so, you know, to your point, you know, for a buyer to go, why is it that you need that much cash on hand? And, and, you know, I don't know that we, we've talked about predictability enough here. And it applies to that, it applies to the predictability of your forecast, it applies to the predictability of collecting your accounts receivable, it applies to the predictability of customers. So being able to highlight repeat customers. And so, you know, they it's just all of this speaks to just good management, you know, principles. And again, you know, we're probably preaching to the choir here, because you all out there doing that and, and driving it through, but when in thinking about preparing, you know, just making sure that that you've got just as much of a microscope as possible around predictability is just going to increase the a, well, it's going to increase the value of the business, it's going to be easier to get a deal done. And it is going to open yourself up to a larger pool of potential buyers. And so that idea of predictability and consistency is, is pretty critical, you know, beyond just the financials.
Ryan Barnett 28:40
Right Right, right. And Matt, while you're rolling here, kind of two topics that one of them is on creating a forecast and looking for the future. And the other one is succession planning. Let's hop on to the let's just kind of go with a just a general forecasting and what advice do you have for companies when they're looking at forecasting for the next few years? And in the methodology or anything around it, or even just having a forecast in general? I'd love to get some general thoughts there.
Matt Lockhart 29:17
Yeah, yeah. Mike, I know you can speak to this as well and add on but, you know, history is the greatest predictor of future success. And so being able to look back at the trends within the business at at the success of the sales organization and the different components of your go to market and being able to say, Okay, well, here's, you know, here's how we've grown in the past and based upon that, and based upon the improvements that we're making within the business, here's how we're going to be growing in the future. And then being able to demonstrate that across a you know, sort of different business units and or, you know, the different capabilities that you have within your firm. And then being able to articulate how, you know, the success that you've done in the past, and the additions of new practices, you know, an example of that is, in the past, we've helped our customers create new go to market capabilities, and those new go to market create capabilities have increased growth, really within a year's timeframe. And so being able to demonstrate how change can have an impact on growth and being able to articulate that. Now, you know, there's some, obviously some promise that is made in that. But the more that you can be able to point to the data, and the experience in the past of articulating that future forecast, I think, the better and, you know, one point I use the word data, right, get your CRM system as tight as possible so that you can point to the data of your pipeline, you know, to sales to them future forecast, Mike, what did I miss?
Mike Harvath 31:30
No, I think you've got it, I think, you know, when a when a buyer is looking at buying you, they're gonna want to have confidence that you can continue on the trajectory of the past, I think whenever you, for example, see a firm of five growth and suddenly hockey stick forecast that brings up a lot of questions about, well, what are you going to do differently tomorrow, to grow the business? You know, certainly up until the right is preferred. But if it's always been up into the right, that's a much easier conversation to have, then, hey, we, we've been struggling the last five years, and now somehow materially, it's going to be up and to the right. I think it's critical to not only have the data, but also be able to articulate and build confidence in your forecast that you will continue to be on this trajectory, and that you have hard evidence for showing that you will. And whether that be through signed contracts, or whether that be through sort of your typical conversion rates, on sales, on marketing, you know, having the data associated with your go to market builds a lot of confidence in a buyers ability to get to their return rate. And remember, that's why they're asking, right? They're asking, because if they're going to acquire your business, they have to chart a path to their return rate on that investment. If there's a lot of questions about whether they're going to be able to get a return, that's not a risk that they're going to take, right? They're going to look at it and say, Yeah, not so much. Right. Particularly if you're exiting the business. As a founder, leader, Owner, you're gonna be like, yeah, that there's too much risk here, we're not going to do it. So having confidence in the future, and being able to, you know, articulate that and being able to have a buyer understand that certainly are super critical.
Ryan Barnett 33:38
Absolutely, very, very interesting. And just to wrap this up, one thought here, and or one topic is really having a critical, it's critical to have someone that will sustain and be with a firm, full disclose. So that can be that can be the director of operations, sometimes sales sometimes as a technology officer, Mike or Matt, open up the either view here, what advice can you give on the succession planning and, and being in a company and this is, of course different if you're staying with the company, but if you're planning to depart, what are buyers looking for when it comes to the team that's left?
Mike Harvath 34:25
Well, I can comment, you know, they want operational leadership, sales, leadership and executive leadership to for the most part, be intact, post transaction. Now, certainly, it may not be a founder who's quote unquote, selling out or exiting, but you'll have to have put those pieces in place prior to going down the journey of a sale, particularly if you're selling Right. They'll all whether you're selling in or selling out, all those things are going to need to be in place, and maybe you play a role as, you know, executive leadership or one of these other roles, or maybe two of those roles, you know, between sales leadership and operational leadership, post close yourself, but they have to have confidence that those roles are going to be fulfilled and how they're going to be fulfilled before they're going to proceed on a transaction. And the more full more you can fortify that within your business, particularly if you're going to be exiting over some period of time, the easier the conversations are, I often say if you're contemplating an exit, you kind of got to work your way out of a job, right? Before you go to market. Because you have to be in a position to say, Hey, you don't really need me, because these three people are running the business, I'm playing a role, as you know, maybe an executive chairman or oversight but I'm generally not playing an operating role in the business, that's a pretty easy conversation to have as it relates to you exiting the business. If you're playing a critical role in sales, or ops, or even executive leadership, that is not easily covered, and you plan to exit the business, that makes it much more challenging to articulate the value of again, how that buyer is going to get to their return rate after you exit, and the risk that's associated with your exit. And so those are certainly things to be thinking about is if especially if you're contemplating selling out and moving on, that need to be in place before you would contemplate a sale.
Ryan Barnett 36:41
That's very, very helpful. Matt, any closing thoughts?
Matt Lockhart 36:52
No, I think it's a great topic. I think that, you know, the only thing that I'll add is is is, you know, we talk to people every single day about this about this subject and, and we've got, you know, really long standing relationships and, you know, it's this, sometimes, you know, it may take more than a year, based upon where your firm is. It's almost like think about it in the context of retirement planning. Retirement Planning doesn't really start one year before you retire, right? And on the flip side, to that, you've got to just operate your business as healthfully and successfully as possible. So it's this sort of bifocal vision of thinking longer term, about the fact that at some point, you know, there's your business is likely going to be sold. Right? And, and so, working strategically towards that long term, while in the short term, you know, with those bifocals, I'm operating the business as successfully and healthily every single day. And so, you know, at that, that's fun to think about both of those things and, and man we love you know, we love talking to our clients about these things and, and helping them out ya know, every step along the way.
Ryan Barnett 38:30
That's great. Mike we'll turn it back over to you to wrap up.
38:35
Thanks, guys, Ryan and Matt, great topic today. With that will tie a ribbon on it for this week's revenue rocket Shoot the Moon podcast. As you know, revenue rocket is the premier m&a and strategy advisor for IT services companies worldwide. We certainly welcome an opportunity to have a conversation about your IT services company anytime, and you can find us at info at revenue rocket.com or on our website. So with that, make it a great week, and we hope you tune in next time. Take care