Avoid These Financing Mistakes That Kill Business Valuations
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Having a well-financed business that doesn’t rely on bad sources of debt goes a long way to making a company attractive to buyers and ensuring that it fetches an attractive valuation. But, the choices that produce a good balance sheet don’t happen overnight; it takes years of preparation to ensure the best possible sale years later.
It’s a good time to sell a small business: in the first quarter of 2017, 2,368 deals closed, up 29 percent from a year earlier, according to BizBuySell’s Insight Report. However, only one in five listings on the online marketplace for selling small businesses closed a deal in 2016. Having good financing is among the most important factors that leads to successful sales. At its simplest, attractive businesses are financed by good debt while unattractive businesses are built on bad debt. Often, decisions about finances made early in the life of a business determine whether or not a business can be sold successfully years later.
Good debt falls into three categories:
- Financing to acquire fixed assets that improve workflow and efficiency or that facilitates more efficient use of labor or assets
- Debt to acquire real estate that can be sold with the business or held after the sale as an additional source of income
- Working capital loans and lines that help the business grow.
Start with a review of the financing and utilization of fixed assets.
Companies should have good, permanent financing in place for at least three years to create the most efficient, cash-flow positive organization. That planning starts with a review of the financing for fixed assets. For example, printing and construction companies are known for buying high-end equipment that is often underutilized. If that equipment is only used 20 percent of the time, it creates a fixed debt cost associated with variable revenues that does the business a disservice by creating a balance sheet where cash flow doesn’t justify debts. Since buyers only care about repeatable cash flow, the end result will be a lower purchase price.
Entrepreneurs that want to sell should review all such balance sheet assets to ensure the company is in good financial health. A business using debt to finance assets that are under-utilized, including machinery and real estate, should rectify the situation. For example, if an asset is being underutilized, it makes more balance sheet sense to sell the asset, retire the debt and sub-contract that work.
Buyers dislike bad debt, which falls into three categories:
- Debt financing underperforming assets or real estate, as detailed above
- Significant credit card debt being used as working capital because the business does not have adequate lines of credit
- High interest rate debts.
While those loans may be convenient and easy to sign up for online, loans with interest rates at 20 percent annually or even higher are a turnoff for a new buyer. While bad debts can be keeping the business afloat, they signal that the business may be difficult to finance.
Having the right type of financing makes sure that the business is operating efficiently and has real cash flow that is repeatable and will continue after the sale. For example, taking on a large loan to upgrade machinery in a way that will boost sales enough to service the debt makes sense for a business as an ongoing concern, but doing it just before a sale will lower the profit of that sale unless cash flows increase accordingly.
Avoid year-end tax and accounting maneuvers that drive down revenue.
Anyone hoping to sell their business should also take care to eschew any tax avoidance schemes such as billing customers after year-end cutoff, paying invoices early, or buying extra equipment or vehicles for the depreciation write-off. Such actions drive revenues down and push costs up artificially, and may make it difficult for the buyer to understand your business and how he or she can make it profitable. That’s never a good thing when trying to sell a business.
Entrepreneurs who took outside investment too early, either from venture capital or elsewhere, and had to give up too much control of the business in return for that cash may find it hard to get the price they want years later in a sale because they own too small of a percentage of their company. Such companies would have been better off raising a smaller amount of funding from friends and family or angel investors to bootstrap the business and retain control.
Owners who took on partners in return for cash early on should have any agreement in writing to avoid any problems later when it comes to selling the company. Picture, for example, a top chef with a partner that supplied the cash to set up a restaurant. In this type of business marriage, a pre-nuptial agreement can save lots of headaches later.
In the coming decade, about 10 million small-business owners hope to sell their company to retire. Businesses that fetch good valuations will have good processes and methods that create profits and will have financials showing positive equity, goodwill being created, and cash flow that is sufficient to service debts and pay the new owner a good salary.