Valuation; a Tricky Business

Will you sell your business now that you are looking at retirement. What is your business worth? 

How much is your business worth?

If you are like many baby-boomers, it is getting close to the time when you'll need to divest from your assets to pay for retirement. It is now time to sell the business. But how much is it worth?
There are many books and articles covering different ways to value a business. Some use profit multiples. Others look at revenues. And there are those from the tech-boom years that focus on future growth.
The reality of it all is that none of these methods matter if the author is not willing to buy the business from you. How much is a valuation worth if no one would pay it? In a market, prices are set by market players willing to sell or buy an asset. Everyone else is just noise.
Let's look at Apple's stock to help us understand better. Two days ago, on January 28th at 10:30 AM, AAPL reached a per-share valuation of $513.00. Today, also at 10:30 AM, each share dropped to $498.69. In just two days, the shares dropped $14.31.

Apple Inc. Logo

The change in price was not due to earnings surprises or anything that could hurt valuation. In fact, Apple's earnings were announced on January, 27th, leaving enough time for the market to adjust.
Can an industry analyst argue that the company remains just as valuable today as it was two days ago? Yes, of course. I am even sure that the analyst would offer great reasons why the valuation should remain at the $513.00 price. But his opinion is garbage. To talk costs nothing and thus has no value. There is no way in hell that Apple is worth the $513.00 today. How do I know? Simple; because no one paid that price. No one who was willing to part from their cash was willing to do it at $513.00. And believe me, with close to 25 million shares sold, there were plenty of opportunities for someone to pay the higher price. Yet, not a single buyer did.
What's interesting is that all sellers would have preferred to sell at the higher price of two days ago. But with no willing buyers, they had to settle for the lower price. Alternatively, their other choice was to sit on the shares and not sell.
The same applies to your business. You may think that your business is worth, say, a million dollars. You may even have documented evidence of why it's worth the price. But does it mean that it's worth the million? No! Not if the highest bidder offers much less for it. This means that you too may have to select between taking a lower price or to not sell if your highest bid is lower than the million.
The problem here is that many business owners never plan an exit strategy. As a result, they usually try to sell the business when they have no more time to wait. This is why, after listing a business for sale with a broker, the owners often get tired and give up. They take home whatever inventory is left and break the lease. From one day to the next, a viable business is closed. Because of a lack of planning and the unwillingness to take a lower price, the owners run out of time and get nothing instead.

Do you have an exit strategy?

Think about it. How many people do you know who are out there looking to buy a business? How many have the money to do so? For sure, I know many people who want to start a business, but they are not thinking about buying one. In fact, most of them lack the business experience to know that brokers exist. Moreover, these aren't the kind of people who would walk into your business to ask if you would sell. So even with willing sellers, these buyer don't know where to find them. In short, there aren't enough buyers available who know where the sellers are. In technical terms, this means that the market of small businesses for sale lacks transparency and liquidity.
When it comes to buyers and sellers finding each other, selling a business is worse than the real estate market. Just the fact that a home seller is willing to advertise to everyone while the business seller isn't should clarify the reasons behind the difference.
Compare this to buying Apple stock. Within a fraction of a second, I can sell my APPL shares without any concern of who is at the other end of the transaction. There is plenty of liquidity in the Apple shares market. Furthermore, I know the exact price it is worth at any time. Pricing information is publicly available through the stock exchanges. Better yet, the price is not determined by analysts but by buyers putting out their cash. There is a high degree of transparency in this market. Clearly, selling your business lacks both, transparency and liquidity in the market. This means that selling requires adapting.

Time compensates for liquidity

What can you do? Well, first understand that allowing plenty of time is essential for a successful sale. This is the only way to compensate for the lack of market liquidity. Plan ahead. Don't leave this until your optimism for the business fades. Most people fail to plan because they think that tomorrow will be better than today. So they get their heads deep into the business. This means that the blinders only come off once they starts losing interest. By that time, doing what's necessary to get a higher valuation for the business will be impossible. It will be too late.
Remember that your goal all these years was to run the business in a way that would give you the highest standard of living rather than the highest valuation. They are not the same. In fact, many common business practices destroy valuations. Now that if this happens to you, don't worry; you are not the first.
Next, you should understand that any valuation given to you by an expert is garbage. The only valuation that you can take to the bank is that from a willing buyer with cash on hand. So, have some flexibility.
There is nothing wrong with thinking that you are the best negotiator in the world and that you will get the best deal; every business owner thinks the same. But no amount of negotiation will reliably help you sell your business if your valuation is unreasonable. If you ask me, I think that your odds would be close to those from playing the lottery. I would advise to take an alternative with a higher probability of success instead.
Think of the following:, buyers do not want to buy your business just to make you happy. Rather, real investors, the kind who would know how to find you, are interested in making money and don't care much about anything else.
To make money is not to buy and sell stuff. Many businesses buy and sell every day until they go bankrupt. High profit percentages aren't good enough either, if sales are so low that receipts do not cover costs. Even high profits in paper are useless. Most naive business owners fall under the trap of thinking that the P&L is all that matters to the business.
No! They don't want funny P&L's. Investors want positive net cash flows. Just look at what commercial banks measure when deciding on a loan for your business. Cash it's what matters. Even Warren Buffet is famous for looking at cash rather than the P&L.

When cash flows are negative

Did you know that Enron had great P&L's before they collapsed? Their whole mirage begun to unravel after short-seller Richard Grubman challenged Enron's CEO, Jeff Skilling, for the absence of a cash flow statement with their earnings during the earnings call on April 17, 2001. In paper, Enron was the most profitable company in the world. But, like a Ponzy scheme, they were running out of cash and needed to create new ways to get capital infusions to stay alive. Just like a Ponzy scheme, they eventually failed; leaving a trail of total devastation. They weren't producing any cash.
So tell me, how much is your business equipment worth if your business is not creating positive cash flows? The answer is "nothing". How much is the building worth, assuming that you own it, if there are no cash flows? Zero! Have you ever heard that many businesses are worth more broken apart than together? Well, you now know why. If your business is located in a building you own, I may advise to sell them separately. If the business produces very little cash, it will drag the value of the building down. Subsequently, a buyer looking at having to buy both may not be willing to pay the price you are asking for; which will surely make you think that the buyer is unreasonable. But in reality the opposite is true. Think of it in the following way. If a buyer seeks to get the highest return on his capital, why would he put cash into a asset that doesn't improve returns. Often, large capital outlays will reduce return on capital. This is why Dell's model is much more profitable than Apple's. Dell never had to use cash to buy a piece of inventory. Apple does.

What is your return on capital?

You see, to buy a building, the buyer will have to park a large amount of money in exchange for small savings with the hope that it will appreciate in the future. This is why businesses who keep a close eye on return on capital prefer to pass the burden of sinking lots of cash to financial institutions and opt to rent instead. This is a way to leverage other people's capital. The math is simple. If you can get higher returns on the cash you have by renting rather than buying, then rent. This is certainly the case when rapidly growing a business. It is best to put valuable cash into whatever yields the fastest turns. And buying a building achieves exactly the opposite. It turns scarce capital into slow money.
I can not stress enough the point that the way you run your business may not be what gets you the highest valuation. Things like high net cash flows, fast growth, and high returns on capital are very important when attracting serious buyers. As you can see, these three prioritize money. Your management style, on the other hand, prioritized you.
Finally, be flexible. Whenever I look for buyers, I always try to find what the buyer values more: P&L, Statements of Cash Flows or Balance Sheet. Are they seeking to show the highest difference between input and outputs? Are they in a capital intensive business or are they growing fast? Are they trying to improve their Debt Ratio? This is because a buyer may be willing to pay a higher price if it helps them improve cash. Terms are a great alternative in such cases. This brings me to asking you: which of the three is most important to you. Knowing what matters to you and to the buyer will help you both get a deal where everybody gets what they want. The message here is that you need to customize to get the best deal.
In conclusion, plan your exit as soon as possible. Do not wait a minute more. After your business earns you a comfortable living, learn the things that can get you a higher valuation. Incorporate this knowledge into your business. Give yourself time to find the best buyer. Be flexible with the price. There are ways to exchange an asset for something other than just cash-at-front. Be creative when making the deal. Good luck.

Math's for Winners - Regression Analysis and an Upset Status Quo

I tend to make some people really mad because of my affinity for data. If in doubt, just look at the feedback I received from a reader to my previous post. He was pretty worked up by the fact that I used statistical distribution to show that his experience agreed with mine. He even went as far as calling me a bourgeois; implying that my methods were snobbish. This comment surprised me since the term bourgeois describes business oriented middle class people instead.

Different Statistical Distributions

To him, my use of data destroyed the human side of business. I can see why, but I disagree. As a result he will not be the last one I upset.
To those like him, their experience tells them that data is the flag of the insecure. Data, or numbers, make anyone sound smarter than they are and keeps others form asking further proving questions. Perhaps worse, data also fails on an almost periodic basis. Who can forget the market catastrophe that resulted from Long Term Capital Management's misguided deployment of Nobel Prize winning mathematics? In 1998, the famous algorithms created a global economic meltdown.

Late Richard Feynman

But this isn't the only example of high-math. Anyone who has studied the work of the late Richard Feynman knows that math can be a structural part of great progress, for example. As speculative as it may have seemed at the time, Feynman's work continues to prove its accuracy and utility.
To me, what makes data fail is not data itself, but our inability to use it properly. Whether an ignorance of what to measure or of how to interpret what was measured, data can prove to be quite difficult for even the most committed. This is especially true for the many who think that math is something that was left behind as we departed from school and that it should have no place in the real wold of business. But science offers this fantastic tool to help us make desired results predictable and repeatable. We just need to learn how to use it properly.

Moneyball by Michael Lewis

A great example of this is illustrated in the great book Moneyball; The Art of Winning an Unfair Game by Michael Lewis. Yes, the same Michael Lewis who used to be a bonds trader and who wrote the Wall Street favorite Liar's Poker.
As a science optimist, I very much loved the book. Reading that Baseball has already demonstrated that regression analysis and statistical rigor can be used for unbelievable performance left me as happy as a child in a candy store. And that says nothing about the fact that the benefits can be quantified in real dollars. Baseball teams pay for success with either dollars or math.
The book is not a dry regurgitation of data. No, it is a fun narration by a writer who has demonstrated tremendous bandwidth and an ability to communicate in the most fluid fashion. If you love baseball, you will enjoy the book. On the other hand, if you are religious about the "proper" way the sport of baseball should be played, then this book will piss you off. The dividing line is quite fine.

Moneyball 2002 Year; source: Wikipedia

Likewise, I know that my insistence in mathematical rigor is welcomed by those with an open mind and hated by the ones who "know how things should be done". Thus, it is helpful to have a very thick skin and a lot of confidence in one's methods.
In the end, math helps the underdog win. And who in America doesn't like to root for the underdog?

Occupy Keystone - to Complain or to Engineer Solutions

Sierra Club - Occupy Keystone 

Do you want factory jobs back in the US? Well, lower fuel costs are neutralizing the effects of low Chinese labor. Now that energy is so much cheaper in the US, factories are coming back.
The same goes for helping consumers save money during a time when they need it. Lower gas costs have pumped lots of money back into consumer pockets. For an idea of how much money has been given back to consumers just wait to see your next gas bill, now that gas supplies weren't enough for this difficult winter.
What's important about these issues is that no politician has anything to do with them. Markets do it on their own.
But to many of the anti-hydro-carbon lobby. None of this matters. They want to complain rather than solve the energy demand problem.

Data Centers - Energy Black Holes

It's easy for whiners to complain about hydro-carbons when the subject of energy isn't well understood.
Whiners complain, yet continue to use washers, refrigerators and now the "cloud". But they are not credible. I see no one picketing outside of appliance stores or the many massive data centers. Do you have any idea of how much energy is wasted to power the "cloud" and the internet? Data centers consume so much energy that it's shameful. But no whiner complains. The ridiculous asymmetry is clear.
Rather than complaining about a pipeline which will not add supply since the supply is already handled by trains, how about all these hipsters study Energy Engineering. I know the math may be intimidating for the lazy types but that would at least try to fix the issue at a fundamental level. The core of the problem is s growing demand for energy and not the supply.
I ask the question of what makes these whiners think that only they can have access to a cars, washing machines, refrigerators and the internet? Nothing.
Because every one in the planet wants the same things, the demand is what will drive massive exploitation of hydro-carbons in the next several years. Complaining about it solves nothing.

Electric Vehicle Battery Pack

Moreover, wind and solar are only feel-good patches. If deployed in mass, these would create new problems of their own. Just think of the problem from managing millions of tons of used-battery waste if all cars were electric.
We need new solutions that can be taken to critical mass without negative effects. This is a problem that can only be solved through engineering. But in the US our children do not have an education level high enough or the dedication to enter engineering schools. I guess that we will have to wait until millions of new Chinese engineers graduate before we can solve the problem.
In the mean time, if whiners can't be part of the solution, they should get out of the way and let the rest of us handle the tasks at hand.

Failure at the Top

What's the most common problem in a failing company? This is the question I am often asked. Who or what is at fault in a struggling business?

Many assume that bad employees or products are the cause

My answer? The top!
In general, once you have worked with a few diverse groups of employees you'll probably also conclude that all have a fairly typical distributions consisting of a star or two, many average performers and one or two who seem to enjoy sabotaging everything. But since this mix is typical in all companies and since all companies perform at different levels, failure must be elsewhere.
Instead, management is generally at the core of the problems. Things like emotional insecurity and dysfunction, abusive tendencies, lack of leadership and outright incompetence are normal characteristics of those at the top of poor companies.
And this would make sense if we think that management's activities are leveraged through the rest of the company's team. A great manager's input would multiply into much larger outputs. Likewise, the inverse would be the case.

Poor leaders display low emotional intelligence

Bad managerial actions create environments with silos, where cannibalism increases the need for shelter and safety. The high degree of distrust prevents synergistic cooperation among team members. Distrust then engenders management's perception of the need to micro-manage employees. Bureaucracy becomes abundant.
In general, employees hate coming to work, have long forgotten about personal or corporate goals and have no time or energy to create value. Yes, this is exactly how a vicious cycle works. A participant's actions reinforce negative systemic outcomes. This repeats time and time again until things spiral out of control.
Unfortunately bad leadership also happens with previously successful managers. Often, markets are so frothy that even bad business practices are rewarded with higher profits; gains that end as soon as the tide turns. Just as the Peter Principle defines that employees will inevitable get promoted to their level of ineptitude, so will bosses.
A previously successful sales person gets promoted to manager and fails due to the lack of adequate skills and understanding. The company then loses a great sales person after he is fired. Even demotion works to eventually end his successful career at the company.
In the same fashion, success in previous environments do not necessarily qualify a leader for the next challenge. Then, since hubris usually appears after a few wins, the manager is rendered blind and incapable of understanding how to solve the new problems being faced. This new take on the Peter Principle focuses on managers rather than employees.

Trust in business is paramount

What is the solution? In technical terms, all vicious cycles require an externality before reversal could happen. An externality is a new outside influence to the system. Applying the right amount of pressure and the correct types of externalities can in fact reverse things enough that a virtuous cycle replaces the vicious one.
But what is an externality in practice? Usually, I am; but you too could be one.
When I come into a company, like the recent factory I worked with, I face the need to quickly and forcefully apply an external force over the key fundamental factors that define the troubles. For example? I must quickly give confidence to all participants that the problem is solvable, and that the right knowledge to to so exists and is well understood.
Trust is essential in a vicious environment before anything else can happen. But do keep in mind that I am not talking about a cumbaya moment. I prefer to stay focused on the reality of the matter by making sure that there are no elephants in the room that have not been addressed. Trust is built through transparency and a commitment to progress in exchange of lots of commitment.
It is also important that the team gets a few immediate wins to start creating positive momentum. This will also show saboteurs that things are no longer safe for them; that the team is now moving positively. I usually do not have to fire bad elements. Peer pressure and group progress sends the best message. Bad players simply quit on their own. I just need to make sure that there's lots of transparency on everybody's actions. Good performers get plenty of team cheers. High-five opportunities increase. Destructive lagers find it uncomfortable and try to save face by leaving. They usually land "a great job" elsewhere.
Standards and peer accolades must remain high through out. If anyone does anything good, I tell the world. The point is to push, push, push in a positive direction, which is what being an externality is all about.

Eliminate Distractions

I also remove distractions to save the energy that will be needed to achieve the new ambitiously high goals. As previously said, bureaucracy is high at these places. Bureaucracy creates friction to movement. So, I temporarily eliminate useless reports and meetings. This creates the sense of clear air around the office. It is paramount to use the new breathing room to push hard for what's important.
While structure is very good once a company has achieved maturity, it could slow down progress in a struggling company that must change to survive. What things? Well, at first it is never clear. The only obvious answer is that something must.
A study of the fundamental constraints to progress and a risk/reward analysis of possible solutions are key. Things that waste resources and offer low returns are then easy to de-emphasize, to put it politely. Hear the sound of sacred-cows falling everywhere.
Next, I begin to create personalized plans that align employee success with company progress. It is my experience that improving employee practices and skills at work also creates benefits to their personal life. So, make sure to help them see the connections between improvements in these two worlds.

In the best teams, everybody wins

This stage is about negotiating for mutual value. Once locating the important points, I must be the relentless couch who drives them to success. Personal progress must be measured often; not for punishment, as it is often used, but to show them how to gauge their good decisions. An important goal is to help employees learn how to independently operate in an upward direction.
As part of my job, I have to try to create a temporary gap between management and their team. I need at least a little separation and some time to improve things. As the source of the troubles, management is usually not very patient. I thus have little time and must act swiftly. Fast visible improvements are key. I must maintain a focus on positives and as much transparency as management can handle. It is not easy but it's what makes the challenge fun.
It goes without saying that costs must quickly be cut, that receivables collection must be accelerated and that supplier terms should be extended. While not a solution themselves, cash and cost improvements grant the time needed to solve things. They are thus very important.
Even when anyone can drive cash and cost improvements, those within the company usually struggle. This too must change. A revived team that has been conditioned to think in terms of cash flows will ensure that cash is never a problem again in the future.

The only hockey-stick chart that works for me
is the one that looks back at factual data

At the end of the day, expect measured performance of the improved team to seem to come right out of a too-good-to-be-true presentation. You know, the same charts showing logarithmic improvements which inevitably raise suspicion.
I too do not believe in hockey-stick charts as a forecasting tool. But when they are used to report on verifiable performance, then I love them.
The best part of working with struggling companies is that I am left with many long term friends; people who have quantifiably outperformed all bench marks.
And how about their bad managers? Well, some get better jobs elsewhere. Others demonstrate that the Peter Principle does not negate improvement-after-failure. In fact, the creation of a virtuous cycle is so infectious that everyone. including management, comes on board.
There is just something fantastic about sharing a golden moment with all these fantastic people. I love doing turnarounds.



Update January 5, 2014
An expert in the matter, commented the following in an e-mail sent directly to me:

"The failure of a company is not always caused by "the top", at best only 65% of the time. The picture that you draw in your article is pretty heavy handed and very convoluted. It reminds me of an old saying, "it is not what you say, but how you say it." 
In my 33+ years as a retained search consultant, I have replaced many a CEO, and the first thing we do is a forensic analysis of what went wrong and why. As I mentioned earlier, failure from the top is only about 65% of the causal factor."

He is right! 
The problem with making any statement like mine is that it comes out as being absolute. And as he correctly observes, there are no absolutes in complex systems. 
My apologies!
I am nonetheless excited to see that his experience results in a close to 65% number. 

Failures at the Top
Typical Outcome Distribution
vs. those from 65% CEO/CFO/COO
and 50% CEO

If we apply a little statistical distribution modeling, we know that it is exceptional to see that such a small group of company employees (CEO's) account for such high number of failure events. Under normal distributions (I am geeking out here), the worst one percent (1%) of any group would be responsible for about 25% of failures. This comes from breaking down the curve of a common 80/20 distribution. 
So a 65% would certainly result from a curve with a very fat head and almost no tail. 
This is not an attempt at being cute. To find what is normal in business and what's not, I always try to look at how observed distributions compare to what would be expected under typical circumstances. In this case, while my implied message that 100% of business failures are due to failure at the top would be absolutely wrong, a 65% of failures coming from leadership would be equivalent to a catastrophic score card for the C-Suite. 
I therefore feel that my comments are statistically supported by the evidence gathered through this gentleman's long experience. 
My goal with my blog is not to just be heard but to open educational discussions, even if in the end it is proven that I am wrong. I thus feel that the value from this update lies on the way that one should benchmark things. 
I once met an executive who religiously followed an exhaustive hiring method. When I asked him how many of the chosen ones would go on to succeed at what was expected of them, he said 25%. 
Well, if I had a monkey flipping coins to decide who to hire, I would end with a random group. It could then be expected for the group to reach a success threshold around 20% of the time. In other words, his results were not much better than those from random luck. Needless to say, I was not impressed with his process, which I though was more of a pacifier than effective. 
On the other hand, one of his industry competitors achieved a 42% success rate hiring for the same positions. Now that was impressive. Any time that one can double expected results, the system is doing good work.
I appreciate the opportunity granted by this gentleman to address what I feel is a very important tool for management.