Industries: Private Equity

The Daily Pitch: Deal Makers Column

This article originally appeared in the March 21, 2018 issue of The Daily Pitch. To view the original article, click here

Currently, at least 7,000 baby boomers—born between 1946 and 1964—per day turn 65 and face the reality of slowing down and considering retirement. This demographic phenomenon first appeared about eight years ago and it’s expected to last for another eight years.

It is also estimated that baby boomers own approximately 4 million businesses throughout the US. Of those 4 million, over 95% are small businesses with less than $500 million in annual revenue. Simple math suggests that over the coming eight years, we might see about 450,000 small business owners looking to make an exit each year. How will we handle the wave of transitions?

As intriguing as this question is, the truth is that the demographic shift hasn’t created much of a wave during the last eight years. The business press has provided a number of reasons for this.

  • There simply are not enough buyers—the Millennials (born between 1981 and 1997) are not of age and the Gen X’ers (born between 1965 and 1980) aren’t as numerous. 
  • There isn’t enough cash available to capitalize the transitions.  This, despite dry powder for PE investments, are at an all-time high.
  • Baby Boomers can’t afford to maintain their lifestyles without their annual salaries, so they aren’t retiring at 65. 

These observations seem reasonable enough, but less than compelling.  Perhaps there is another factor influencing the situation. Maybe small business owners simply don’t know how to get out. They have been the creator, manager, cheerleader, and boss; their identity is completely wrapped up in their business. To get out is almost unthinkable. What will I do? Who could take it over?
The emotional aspect of “getting out” has been the subject of numerous articles and studies. This very real aspect of any business transition must be handled first, before any real preparation, due diligence or negotiations can ensue. The truth is that small business owners face a sense of loss and the “grieving” has to be recognized and processed. But, the emotional side of a business’ transition is not the subject of this article. It is the related business side which we address. 
Every business transition relies on something called transferable entity value (TEV). TEV describes the entity value developed and maintained by current ownership, which can be transferred and replicated by subsequent owners.  Any asset’s value hinges on a buyer’s ability to use it to generate positive cash flow. But TEV does not just calculate the value of hard assets which you might find listed on the balance sheet. TEV describes the value of leadership and management processes which can be transferred to a buyer. It describes brand value, marketing programs, and the value of administrative efforts employed by owners. TEV is the value which the business owner can pass on to a buyer, independent of economic or market forces or the availability of financing. TEV is not market value—market value describes the value at which a transaction takes place. 
TEV is particularly relevant for small business owners, who often have underdeveloped leadership processes and operating systems which are reliant on the business owner.  This represents value which is difficult for subsequent owners to realize.  An inability to create TEV likely suppresses deal flow because of lower valuations.
The good news is, since TEV is the by-product of improved systems and processes, it can be taught. Value can be developed through learning. This is a big undertaking, even in a small business.  It is a process best devised and best begun years before a transition might be considered. However, this is not likely—business owners are simply too busy to take on the task.
The rest of this paper is going to offer some specific thoughts and recommendations for increasing TEV.  They are organized in line with the major functions of the business. If you know anyone approaching a transition, share it with them. If that someone is you, good luck and have fun: 
Assuming the business is privately held, consider forming an advisory board. Senior-level professionals will be able to offer very valuable advice. Make sure that at least two of the board members come from outside the company.  Be prepared to pay the board members for their time. Hold them accountable and hold yourself accountable. Use them as a sounding board and a resource for TEV development.
Make sure that every member of the management team has a job description. These are incredibly important to potential buyers and they’re valuable in terms of improved performance as well. There is no reason not to have job descriptions. Even the owner/operator needs one.
Arrange for a monthly meeting with the company CPA or accountant.  Discuss current financial performance, financial strategy and accounting issues. The couple of hours spent will be the best investment you ever make. If your current accountant isn’t good enough for this—get a new one.
Do a marketing analysis. What constitutes the company’s most probable customer? Can the factors that separate them from the others be identified? Does the company have a clear approach to marketing and selling to them?  This exercise is very important to a potential buyer. A buyer can’t understand your customer too much.
Sales Process
Does a sales funnel exist? Carefully consider who your target market is. Suspects, prospects, leads, opportunities and new customers need to be defined and this information needs to be put in writing. Your whole business development team needs to speak the same language. Establish your metrics for business development success—this has a big impact on TEV.  
Small businesses have many unique attributes. But identifying and enhancing the things that insure the basic elements of value are the key for a successful and lucrative transition—when your time comes! Transition planning can be a complex process—make sure you have access to experienced professionals who will maximize the chances of an optimal outcome. A good advisor will get you ready to reap the fruits of your legacy.
Edward Webb is a partner in BPM’s Advisory Practice Group. He leads the Firm’s Corporate Finance Practice and has over 30 years of experience advising businesses of all sizes through difficult situations. Edward can be contacted at [email protected] or 408.961.5543.