Bob had come to us with high expectations as to the price he thought his company would sell for as he approached his expected retirement date. He was certain of this because he had seen other “similar” companies sell in the past for a 1.2X multiple of gross revenue. He figured his company would easily sell for the same.
However, what Bob had failed to understand was that buyers are only partly interested in top line revenue. More important to a company’s selling price is the future net cash flow the company can reasonably be expected to produce. If you can predict what the company’s cash flow will be, when it will occur, and whether a buyer can achieve this when it buys the company, then you can reasonably estimate the company’s “transferable value”.
Bob’s gross margin and bottom line failed to live up to industry standards, which meant he wasn’t likely to achieve the price or retirement he had envisioned. Most importantly, however, was that our study of his industry told us his business model was likely dying. Unless he invested in some new directions, he could soon be driving his company into the ditch.
Bob had what we call an “Iceberg” Exit Plan. He had only envisioned the tip of the iceberg as to what is needed for a successful transition and future exit.
Research shows there are 12 principal reasons business owner transitions, successions and exits fail. Each of these reasons impacts the company’s longevity and ongoing annual profitability as well as an owner’s transition and future exit results. This article addresses the second of these 12 reasons:
Reason #2. Future Cash Flow Impact On Company Price (Transferable Value) Is Misunderstood: You haven’t understood your exit price is dependent upon an inside or third-party buyer’s expectations and specific needs regarding your company’s future net cash flow.
Bob had been focusing on the smooth ride he had been enjoying. However, like Blockbuster when faced with NetFlix, the bridge was washing out up ahead, and he was driving with his headlights turned off.
A company’s true “transferable value” depends on having a business system based on a business model which can produce predictable net, positive cash flow for the indefinite future.
This cash flow is typically measured by your EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). A company’s “transferable value” (and selling price) is often measured as a multiple of this (typically ranging from a multiple of 3X to 8X, depending on the business, the industry and market conditions).
Key to this future value is a viable, sustainable business model. “Business models are living much shorter lives these days.” (Fortune Magazine, October 2, 2006). Business model changes are “occurring in rapid-fire succession.” (IBM 2010 Global CEO Study “Capitalizing on Complexity”). According to this study, CEOs are “instituting continuous change through business model innovation.”
Consider what the following companies have in common:
|A & P||Horn and Hardart||Woolworth|
|Studebaker||Hudson Motor Car Co.||Bethlehem Steel|
|Bonwit Teller||Indian Motorcycle||Polaroid|
|TWA||Montgomery Ward LTV|
They were all successful, recognizable brands in their respective industries. They were all publicly traded. They all failed to innovate (along with hundreds of other equally recognizable names). They created and lived with a “static business model”. (Duquesa Marketing (2010)).
And they failed! To put it bluntly, if your business is not built on a continually developing, relevant, sustainable, business model, then your transition and future exit will fail because your “transferable value” won’t be there. Successful business buyers today “think of the target in terms of its business model” to really judge the value being transferred. (“The New M&A Playbook”, Harvard Business Review, March 2011).
What good is your estimate of business value if you have failed to keep your business model viable, valued and valuable? What good is a business appraisal by an otherwise qualified appraiser, if he or she has failed to consider this?
Bob’s principal line of business was the repair of key component parts for aircraft engines. This for years had been a steady, predictable business (so a review of past financial results looked pretty good). During the course of routine aircraft engine overhauls, as key parts were identified for maintenance, his company could be called on for repairs. As long as he could repair the part for 40% of the cost of a new replacement, he got the contract.
Things were about to change. Just as we now throw away (rather than repair) radios, TVs and computers when they break, the aircraft engine manufacturing industry is trying to head in the same direction (possibly within the next decade). This is due largely to new technology which enables aircraft engines to run at a cooler level.* If you are just in the aircraft engine repair business, your business may soon go the direction of the TV repair man.
Bob needed to begin to direct part of his highly skilled, talented workforce, his key resources, and his R & D budget towards becoming an original equipment manufacturer (OEM) for one or more key components which would be used as part of this new era of aircraft engines. As our Business Model Program (based on our collaborative involvement in the internationally acclaimed “Business Model Generation” project) pointed out to Bob, only with this new back-up innovation to his business model could his company reasonably expect to produce in the future the level of net cash flow it produced in the past. And, he needed to do this while continuing to profitably operate his present business model.
Bob’s retirement would be delayed. But in the end, Bob has adjusted his course and is steering his company in a direction which will be prepared if and when this industry shift occurs. This is his best bet for producing a solid, predictable cash flow and a real “transferable value” that can command the kind of price he wants to achieve.
*This Newsletter contains no information that can be used to identify a specific client. The described transformation in the aircraft engine industry is expected to occur. This illustration, however, was not the business in which our specific client was engaged.
Next Newsletter – How Charlie’s “Let My Spouse Deal With It” Exit Plan sank the family legacy he had worked for.