Built to Sell – Excerpt

Financial 4 May 2010 | 0 Comments

Excerpt – Built to Sell by John Warrillow

8 steps for creating a sellable service business

There are many reasons for wanting to create a sellable business. You may want to retire, travel, cash out or just sleep well at night knowing you could sell your business if you needed to. Unfortunately, however, just 1 out of 100 Canadian business owners are successful in selling their company each year.

The reason so few business owners are successful in selling their company is that the business has become too reliant on its owner. The owner is the subject matter expert, so customers ask to deal with the owner; the owner becomes personally involved in delivering the product or service, reinforcing the customer’s dependence on the owner; the customer, in recommending the business to friends, suggests they ask for the owner; and the cycle continues. A business reliant on its owner is hard to sell, so the owner becomes trapped in the business.

An important note before you embark on the eight-step journey outlined below: Engage a good accountant with experience helping business owners with succession planning. In Canada, many small business owners qualify for a one-time capital gain exemption of up to $750,000. If your business is worth more than $750,000 and if your spouse or kids are shareholders, there may be ways to legitimately and ethically multiply this exemption. However, in order to qualify for the capital gains exemption, shareholders must hold their shares for at least two years. There are a number of other criteria you need to meet so talk to an account about your succession plans at least two years before you want to sell.

Step 1: Create a Standard Service Offering
The first step in building a sellable company is to find a service your clients find valuable that you can teach someone else to perform. Brainstorm all of the services that you provide today and plot them on a simple diagram with “Teachable” on one axis and “Client Value” on the other.

Normally, you’ll find that the most teachable services are the ones clients value the least. Similarly, you’ll find that the services your clients value most are the least teachable. Once you’ve worked through all of the services you offer, eliminate those a client needs to buy only once. Of the remaining services, pick the one that is plotted closest to the top right corner of the graph (pictured above)—this is the service that is both highly valued by clients and can be taught to someone else. This becomes your Standard Service Offering.

Experiment with bundling a few services together to stake out the top right corner of the diagram. You may discover that, by combining one or more services, you can create the ideal offering.

Once you’ve isolated the service(s) that clients value, need often, and is teachable, document your process, defining each step, for delivering this type of product. Write instructions that are specific enough for someone to follow independently by using examples and fill-in-the-blank templates where possible. This becomes your instruction manual for delivering your Standard Service Offering. Test your instructions by asking a person or team to deliver the service without your involvement.

Be patient. Getting the instruction manual right will take time. Expect to create many drafts.

Next, name your Standard Service Offering. Naming your offering gives you ownership of it and helps you differentiate it from the services of potential competitors. Once you are the owner of something unique, you move from offering a commoditized service to offering one whose terms of use, price and payment terms you decide.

Finally, write a short description of the features and corresponding benefits of each step used to deliver your service. Use this copy to revamp all of your customer communications (e.g., website, brochure) so that they provide consistent messaging to customers and potential customers.

Step 2: Create a Positive Cash Flow Cycle
A positive cash flow cycle leaves you with the cash to operate without diluting yourself. If you’ve branded your Standard Service Offering properly, you can create a positive cash flow cycle by charging up front for the service. It’s not unheard of to have clients pay $100,000 or more in advance for a Standard Service Offering that is delivered over the course of a year.  (Depending on your service, you may not be able to charge the entire amount in advance, but you can try. You’ll be surprised at how many clients agree to this arrangement.)

Computer giant Dell proves an excellent example of how a positive cash flow can benefit a company. Dell used to inventory parts, paying suppliers for the gear it kept on hand to make computers when customers called. The company ran short of cash, almost choking on its own growth. Galvanized by the near-death experience, Michael Dell set out to remake his company’s cash flow by charging customers before buying the parts needed to build their computers. By reversing the typical cash cycle, he was able to use his customers’ money to fuel his growth, which meant he required very little external money to grow the business.

If you maintain a positive cash flow cycle, you’ll get more for your business when you go to sell it. Positive cash flow businesses are worth more because (1) acquirers do not need to commit their capital to funding their day-to-day operations and (2) the bottom line is fatter because positive cash flow businesses do not incur financing expenses and they often have some investment income to juice the revenue line.

Step 3: Hire a Sales Team
Once you have created, packaged, and started to charge for a Standard Service Offering, you need to remove yourself from selling it. Business owners often rely on their own rainmaking to supplement their staff’s sales. But who will top up the funnel when you’re gone? If you’re doing the selling—even if you have others delivering the service—you will not be able to sell your business without a long and risky earnout (delayed proceeds based on specific targets’ being met).

So you need to hire salespeople. If you have done a good job packaging a consistent service, the best salespeople will be those used to selling a product. Look for salespeople for whom the selling comes first and the product second. Avoid those who come from professional services companies, as they will want to reinvent your service for every client.

If at all possible, hire at least two salespeople, not just one. Salespeople are competitive and will want to outdo one another. Also, a potential buyer will want to see that you have a product that can be sold by salespeople in general and not just one superstar salesperson.

Step 4: Stop Accepting Other Projects
At this point, stop taking on projects that fall outside of your Standard Service Offering. It’s tempting to accept other projects because they bolster your revenue and cash flow. But if you’re charging up front for your service and your salespeople are selling it, then you shouldn’t have to worry about cash flow. That leaves revenue as the reason to accept projects outside of your process. The revenue may look good at first, but it comes at unacceptable costs: (1) Your team will lose focus, potentially giving undue attention to the “different” project; (2) realizing that you’re not serious about your process, clients will see a chink in your armour and start asking for customization of their projects; and (3) you may need to hire other people to deliver such services. Most important, when you present your business to a potential acquirer, he or she will see the mix of revenue from your Standard Service Offering and other project work and determine that you’re just another service business.

Most business owners who have made this transition will tell you that clients who used to ask for custom services respect the change they made to their business model. Many clients actually buy more once the service is standardized. Clients are smart; they often will recognize that by accepting assignments that fall outside of your sweet spot, you’re overreaching your capabilities. In most cases, they use you for these services simply because they know, like and trust you. This vote of confidence doesn’t mean you need to accept jobs beyond your defined scope.

This step is the toughest part of the process of creating a sellable company. You will have employees testing your resolve and clients asking for exceptions, and you will second-guess yourself on more than one occasion. This is normal; you have to remain strong on this and resist the temptation. It takes time, but at some point, the wind will start blowing the other way, and your clients, employees and stakeholders will realize that you’re serious about focusing on one thing. It will happen, and when it does, you will have taken a giant step toward creating a sellable company.

Now the bad news. Expect the year that you make the switch from accepting projects to focusing on your Standard Service Offering to be a bad financial year on paper. If you’re charging up front, your cash flow should remain positive, but your accountant will need to change the way he or she recognizes revenue by spreading it out over the life of the delivery period of your Standard Service Offering. This has the effect of lowering your revenue in the current period while putting revenue on the books in future months.

Once you have focused on a Standard Service Offering for which you charge up front, and you have sales reps who are capable of selling and employees who are capable of delivering without your involvement, you need to create a two-year run of increasing business and financial performance. This time requisite often frustrates business owners who have made the decision to sell their business. But these two years will dramatically increase the cash you get up front for your business and minimize your reliance on an earnout.

Spend these two years driving the model as far and fast as you can. Avoid the temptation to get personally involved in selling or delivering your Standard Service Offering. Instead, work on refining your processes. When you’re asked for help, diagnose the problem and fix your system so the problem doesn’t recur.

Many business owners realize a tremendous uptick in their quality of life in these two years. Business improves, cash flow grows, workload lessens, and client headaches decrease. In fact, many business owners like this stage so much, they shelve their plans to sell their company and decide to run it in perpetuity. If this happens to you, congratulations! If you still want to sell your business, continue on to the next step.

Step 5: Launch a Long-Term Incentive Plan for Managers
You need to prove to a potential buyer that your management team can run the business after you’re gone. What’s more, you need to show that the management team is locked into staying with your company after acquisition.

Avoid using equity to retain management as it will unnecessarily complicate the sale process. Instead, create a long-term incentive plan for your key managers. Every year, for each manager you want to retain, take an amount equivalent to his or her annual bonus and put it aside in a long-term incentive account earmarked for that manager. After a three-year period, allow the manager to withdraw one-third of the pool annually. If you implement this method, any manager who considers leaving the company would have to walk away from a significant amount of money—something most would not be willing to do.

A long-term incentive plan may be described in an employment agreement as follows:

“Each year, you will be given an annual cash bonus based on goals the company sets out for you. This annual cash bonus will be paid within 60 days of the calendar year-end. In addition, an amount equal to your cash bonus will be earmarked for you in a long-term incentive plan (LTIP). Upon the third anniversary of the creation of the long-term incentive plan, and every year thereafter, you will be entitled to withdraw one-third of the plan’s total balance.”
Step 6: Find a Broker
For those business owners who are committed to selling, the next step in the process is to find representation. If your company has less than $2-million in sales, a business broker will serve you well. If you have more than $2-million in sales, a boutique mergers and acquisitions firm is probably your best bet. Look for a firm with experience in your industry since it would already know many potential buyers for your business. To find an M&A firm or business broker, ask other entrepreneurs, your banker or your accountant for a recommendation.

Take note: A broker who considers your business to be no different from the commoditized service providers in your industry should not be your broker. He or she needs to appreciate that you have created something special and deserve to be compensated at a higher rate.

Once engaged, your M&A firm or broker will work with you to create “the book.” This document describes your business and its performance to date and provides a business plan for the future.

Brokers typically charge a percentage of the proceeds of the deal in the form of a success fee.

Step 7: Tell Your Management Team
Once a prospective buyer is on the horizon, your broker will set up presentations for you and your management team to present your business to the potential buyer. Telling your management team that you’re selling the business can be a daunting task. It’s essential to consider your managers’ perspective and to make sure there is something in the deal for them if it goes through.

For some managers, an acquisition can mean significant career opportunities, and that may be enough. For others, you may need to emphasize that, if the business is acquired, your managers will be more likely to hit their personal bonus targets (which will benefit them twice if you have created a long-term incentive plan as described in Step 5). You may also want to offer key employees a simple success bonus if a deal goes through. Offer to pay the success bonus in two installments, with one installment coming 60 days after the close and the other at some point further into the future. A potential acquirer will like that you’ve put a deal-related incentive in place for your key employees to encourage them to stay.

Step 8: Convert Offer(s) to a Binding Deal
Once you have completed your management presentations, you will hopefully get some offers in the form of a non-binding letter of intent (LOI). As you review an LOI, keep in mind that your advisers will be trying to sell the benefits of the offer to you because (1) they’ll get paid if the deal goes through and (2) they want to remind you of the hard work they have done to justify their fee. This is normal and to be expected, but do not be swayed by it.

The offer will likely contain an amount of money (or some other currency, like stock) up front and another chunk tied to one or more performance targets for your business after the sale, often referred to as an earnout. Treat the earnout portion as gravy. An earnout is simply a way for an acquirer to transfer his or her risk in buying your company onto you. Although earnouts have proven lucrative for some owners, most with service-based businesses who have accepted an earnout contract can share a nightmare story involving an overbearing parent company not delivering on what was promised. As long as you get what you want for the business up front—and treat the earnout as gravy—you can walk when things get nasty. If, however, you feel as though you have to stay to get full value for the business, life can be uncomfortable for the duration of the earnout.

Keep in mind that the letter of intent is generally not a binding offer. Unless it includes a breakup fee (rare for smaller companies), the buyer has every right to walk and leave you with nothing.

A due diligence period, usually 60–90 days, begins once the LOI is issued. Deals often fall through in the due diligence period, so don’t be surprised if it happens to you. This period isn’t fun, and the best strategy is just to survive it. Due diligence can make you feel vulnerable and exposed. A buyer who is a professional will dispatch a team of MBA-types to your office, who will quickly identify the weak spots in your model. That’s their job. Try to keep your cool during this period. Try to present things in the best possible light, but do not lie or hide facts.

Once the due diligence period is over, there is a good chance that the offer in the LOI will be discounted. (Again, don’t be surprised if this happens to you. Expect it, and you’ll be pleasantly surprised if it doesn’t happen.) You’ll need to go back to the math you did when reviewing the LOI the first time. If the new offer meets your target cash up front, go ahead and agree to it. If the discounted offer falls below the threshold, walk away no matter how much the acquirer promises to help you hit your earnout.

If you accept the revised offer—or if the due diligence period ends—you’ll have a closing meeting. Typically held at the acquirer’s law firm, this powwow addresses the formalities. You sign a lot of documents, and, once they’re all signed, the law firm will move the cash portion of the sale from its account to yours. The deal is done.

This article is based on John Warrillow’s new book Built To Sell: Turn Your Business Into One You Can Sell. If you’re curious to see if you have a sellable business (and what you could get for it) take the “4-minute Sellability Index Quiz” at www.BuiltToSell.com

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